Description
This paper seeks to examine the relationship between corporate governance and the
value-relevance of accounting information in Australia
Accounting Research Journal
Corporate governance and the value-relevance of accounting information: Evidence
from Australia
Ahsan Habib Istiaq Azim
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To cite this document:
Ahsan Habib Istiaq Azim, (2008),"Corporate governance and the value-relevance of accounting
information", Accounting Research J ournal, Vol. 21 Iss 2 pp. 167 - 194
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Corporate governance
and the value-relevance
of accounting information
Evidence from Australia
Ahsan Habib
Department of Accounting, School of Business,
Auckland University of Technology, Auckland, New Zealand, and
Istiaq Azim
Division of Business, School of Commerce, University of South Australia,
Adelaide, Australia
Abstract
Purpose – This paper seeks to examine the relationship between corporate governance and the
value-relevance of accounting information in Australia.
Design/methodology/approach – This paper uses board, audit committee and external audit
related variables to proxy for corporate governance. Value-relevance is measured by the adjusted R
2
derived from a regression of stock price on earnings and equity book values following Ohlosn’s
accounting-based valuation framework.
Findings – Regression results show that ?rms with strong governance structure exhibit higher
value-relevance of accounting information. Results further show that ?rm-speci?c economic variables
are important determinants of the value-relevance of accounting information.
Research limitations/implications – Signi?cant regulatory reforms regarding corporate
governance around the world give an impression that regulators believe that governance plays a
key role in ensuring, among others, credible ?nancial reporting. This paper provides support for such
a view in Australian context.
Originality/value – This paper uses the relationship between accounting numbers and share price
as the measure of accounting information quality and also considers the impact of ASX Corporate
Governance Best Practice Code on the changes in the value-relevance of accounting information.
Keywords Corporate governance, Accounting, Accounting information, Australia
Paper type Research paper
1. Introduction
This paper examines the relationship between corporate governance structure and the
value-relevance of accounting information in Australia. The recent spate of corporate
collapses around the world has put signi?cant pressure on policy makers and
corporate management to initiate and implement good corporate governance practices.
Australia experienced some signi?cant corporate crises in 2001 with big companies
like HIH Insurance, One.Tel and Harris Scarfe going into liquidation. In August 2002,
the Australian Stock Exchange (ASX, 2003) formed the ASX Corporate Governance
The current issue and full text archive of this journal is available at
www.emeraldinsight.com/1030-9616.htm
The authors appreciate helpful comments from an anonymous review and participants of the
2006 AFAANZ conference in Wellington. They are responsible for all errors.
Corporate
governance
167
Accounting Research Journal
Vol. 21 No. 2, 2008
pp. 167-194
qEmerald Group Publishing Limited
1030-9616
DOI 10.1108/10309610810905944
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Council consisting of 21 constituencies, to develop recommendations for Australian
?rms that re?ect international best practice in corporate governance. ASX developed a
“principles of good corporate governance practice” code in 2002. ASX categorised
corporate governance practices into the following:
.
solid foundations for management and oversight;
.
value-enhancing board structure;
.
ethical and responsible decision-making campaigns;
.
ensuring integrity in ?nancial reporting;
.
making timely and balanced disclosures;
.
respecting the rights of shareholders;
.
recognising and managing risk;
.
encouraging enhanced performance;
.
executive remuneration that aligns interest of the executives with those of the
shareholders; and
.
recognising the legitimate interests of stakeholders.
The Council expects good corporate governance structures to create value by
providing value-relevant accounting information in the marketplace (Koh et al., 2007)
This paper tests that proposition by examining the relationship between governance
structures and the value-relevance of accounting information[1] in the Australian stock
market.
The Australian corporate system offers a unique environment for assessing the
impact of corporate governance mechanisms on the value of ?rms. Australian ?rms,
unlike those of Germany or Japan, have board structures and mechanisms that are
typically Anglo-Saxon in design. However, the Australian market for corporate control
is not as active as in the USA and the UK, and its effectiveness in inducing boards to
monitor closely, and take corrective action in cases of failure, might not be comparable.
This makes the role of internal governance mechanisms such as independent boards,
and audit committees (AC) more important. Furthermore, recent corporate collapses
experienced by Australia[2], albeit smaller in magnitude than those in the USA, like
ENRON and WORLD.COM, have still prompted policy makers to tighten corporate
governance regulations[3].
From an academic perspective, corporate governance is an extensively researched
area in the literature on accounting (Cohen et al., 2004). However, the impact of
corporate governance on the value-relevance of accounting information remains
unexplored. Agency theory arguments support the view that better structured
governance mechanisms should result in better quality ?nancial reporting in the
marketplace. The separation of ownership and control gives rise to information
asymmetries that managers could use to exploit outside atomistic shareholders (Berle
and Means, 1932; Jensen and Meckling, 1976). Shareholders demand ?nancial reporting
from managers in order to evaluate the performance of managers. However, in the
absence of strong monitoring mechanisms on managerial behaviour, managers could
mislead outsiders by providing ?nancial information which does not portray the true
underlying performance of the business. In such cases, accounting information is of
little use in valuing companies, and no association between market price and
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accounting information would be expected. Corporate governance mechanisms are
assumed to constrain management opportunistic earnings behaviour and,
consequently, to make accounting information more credible and relevant to outsiders.
The role of accounting numbers in company valuation is of fundamental interest to
analysts, investors and researchers alike. Prior work on the value-relevance of
accounting information has demonstrated that both income statement and balance
sheet information are useful in determining equity values (Collins et al., 1997; Francis
and Schipper, 1999). Much of the accounting-based valuation has focused on analysing
historical and forecasted accounting numbers (Richardson and Tinaikar, 2004). The
work of Ohlson (1995) and Feltham and Ohlson (1995) have produced considerable
interest amongst researchers about the role of historical accounting numbers in
valuation. Ohlson (1995) links earnings, equity book values, dividend and other
relevant information to stock price by integrating the dividend discount model, clean
surplus equation and linear information dynamics[4]. This paper utilises Ohlson’s
(1995) valuation framework to test the impact of corporate governance on the
value-relevance of accounting information.
This paper hypothesises that accounting information will be more strongly
associated with market price for ?rms with strong governance structures. This is
because managers of such ?rms will have fewer opportunities to engage in earnings
management due to strict monitoring exerted by an independent board and AC, two of
the most important corporate governance mechanisms. Klein (2002) for example, ?nds
that managers report less income-increasing accruals when the AC and board are
dominated by external independent directors. Value-relevance of accounting
information, however, is also affected by ?rm-speci?c factors and it is important to
control such variables in order to isolate the corporate governance effect on the
value-relevance of accounting information. Following extant literature (Collins et al.,
1997), four such variables are included in this study, namely:
(1) negative earnings;
(2) ?rm size;
(3) growth opportunities available to the ?rm; and
(4) ?rm leverage.
Corporate governance data used in the subsequent analysis is collected from the
annual reports of the top 500 Australian companies for 2001-2003. A principal
component analysis (PCA) is performed to reduce the large number of corporate
governance variables into three factors: the ?rst representing board and AC
composition; the second, board and AC independence (ACIND); and the third, audit
quality characteristics. Value-relevance of accounting information is measured as the
adjusted R
2
from a regression of stock price on earnings and equity book-values.
Empirical results reveal that strong corporate governance structures increase the
value-relevance of accounting information. This result holds after controlling for the
?rm-speci?c factors hypothesised to affect the value-relevance of earnings.
The paper proceeds as follows. Section 2 discusses the theoretical framework and
surveys the related literature. Section 3 describes the research methodology used in the
study. Sample selection procedure and descriptive statistics are described in Section 4.
Section 5 presents the substantive test results, and Section 6 concludes.
Corporate
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2. Theoretical framework and survey of the related literature
An accounting amount is de?ned as value relevant if it has a predicted association with
equity market values (Barth et al., 2001). Financial Accounting Standards Board (1984)
Conceptual Framework speci?es relevance and reliability as the two primary criteria
for choosing among accounting alternatives. Statement of Financial Accounting
Concept (SFAC No. 5) proposes that an accounting amount will be considered relevant
if it is capable of making a difference to ?nancial statement users’ decisions. Barth et al.
(2001, p. 80) note that:
[. . .] an accounting amount will be value relevant, i.e. have a predicted signi?cant relation
with share prices, only if the amount re?ects information relevant to investors in valuing the
?rm and is measured reliably enough to be re?ected in share prices.
An extensive body of market-based accounting research (MBAR) tests for relevance of
accounting information by investigating the association of such information with
equity prices (Ball and Brown, 1968 is the pioneering study)[5]. MBAR research relied
on earnings, or a component of earnings, as explanatory variables for security returns.
This is logical, because the valuation theory has long posited a relationship between
earnings and the value of common stock (Miller and Modigliani, 1961; Graham et al.,
1962). Subsequent analytical work by Ohlson (1995) includes another valuation
construct, book value of equity, along with earnings in tests of market pricing of
accounting information. The rationale for such inclusion is premised on the
assumption that book value of equity is a proxy for the present value of expected
future normal earnings, which equals beginning of year book value multiplied by the
cost of capital. Another argument for supporting the valuation relevance of book value
of equity is that it re?ects a ?rm’s liquidation or abandonment value (Berger et al.,
1996; Burgstahler and Dichev, 1997; Barth et al., 1998). Collins et al. (1999) provide
evidence that equity book value acts both as a proxy for expected future normal
earnings and adaptation/liquidation value. Value-relevant accounting information
represents a desirable attribute of ?nancial reporting quality. Support for the
value-relevance of earnings comes from studies of the ERCs (Kormendi and Lipe, 1987;
Collins and Kothari, 1989; Easton and Harris, 1991).
Much accounting-based valuation has focused on analysing historical and
forecasted accounting numbers (Richardson and Tinaikar, 2004). The work of
Ohlson (1995) and Feltham and Ohlson (1995, 1996) has produced considerable interest
amongst researchers about the role of historical accounting numbers in valuation. The
attractiveness of the Ohlson model (OM) to empirical researchers is that it provides a
testable pricing equation that identi?es the roles of accounting and non-accounting
information, incorporating abnormal earnings, equity book values and “other
information” variables (Lo and Lys, 2000). Lo and Lys also identify other reasons for
the popularity of OM, in particular, the high R
2
achieved in most OM studies. This
provides a satisfactory response to Lev’s (1989) dismal ?ndings of very low correlation
between return and earnings. This high R
2
also suggests that “little value relevance is
related to variables other than book value of equity, net income and dividends” (p. 338).
Finally, the very high-explanatory power of the model leads researchers to conclude
that the OM can be used for policy recommendations.
However, managerial incentives to maximise their personal wealth could lead them
to provide biased accounting information to outside investors. Separation of ownership
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and control gives rise to information asymmetries between managers and outside
shareholders (Berle and Means, 1932; Jensen and Meckling, 1976) which provides
incentives to the managers to supply biased ?nancial information with the intent of
exploiting outside shareholders. Empirical evidence suggests that resource
mis-allocation can occur when investors fail to detect such biased reporting. For
example, Beneish (1997) ?nds some evidence of signi?cant abnormal returns from a
trading strategy based on an opportunistic generally accepted accounting principles
(GAAP) violation. To minimise sub-optimal managerial actions resulting in resource
mis-allocation, researchers have identi?ed a number of pure market forces, such as
product market competition (Alchian, 1950), the market for corporate control (Manne,
1965), and labour market pressure (Fama, 1980). However, despite these market forces,
there remains residual demand for additional governance measures, including boards
of directors, AC, ownership structures, etc. This demand is documented in the large
body of corporate governance research (Shleifer and Vishny, 1997; Bushman and
Smith, 2001; Denis and McConnell, 2003; Hermalin and Weisbach, 2003; Cohen et al.,
2004). From a ?nancial reporting perspective, a desirable consequence of corporate
governance is hypothesised to be the provision of high-quality accounting information
to ?nancial statement user groups. This may occur through at least two channels.
Firstly, corporate governance should provide high-quality accounting information
by curbing opportunistic earnings management practices of managers. An extensive
body of empirical literature documents the existence of opportunistic earnings
management[6]. When mangers manage earnings for opportunistic purposes,
accounting earnings become a less reliable measure of a ?rm’s ?nancial
performance. An effective corporate governance system ensures the provision of
credible accounting information to ?nancial statement user groups by constraining
opportunistic earnings management by managers. Corporate governance also helps
investors by aligning the interest of managers with the interests of shareholders and
enhancing the reliability of ?nancial information and the integrity of the ?nancial
reporting process (Watts and Zimmerman, 1986). Empirically, Klein (2002) ?nds a
negative relationship between AC- and board-independence and abnormal accruals.
Davidson et al. (2005) show that two of the corporate governance attributes, namely, a
majority of non-executive directors on the board and on the AC are negatively
associated with the likelihood of earnings management in Australia. Larcker et al.
(2007), on the other hand, ?nd that a comprehensive set of different governance
measures explains only 0.6-5.1 per cent of the cross-sectional variation of the dependent
variables, like abnormal accruals, Tobin’s Q, accounting restatements, etc. Larcker et al.
(2007) attribute the failure to ?nd any consistent relationship between corporate
governance measures and organizational performance to the dif?culty in generating
reliable and valid measures for the corporate governance construct. Brown and Caylor
(2006) ?nd support for the positive role of corporate governance measures in
value-creation based on a composite governance measure of 52 variables. Brown and
Caylor (2006) also show that the two most important governance categories are the
board of directors, and executive and director remuneration.
Secondly, the interaction between corporate governance and corporate disclosures
could also affect the value-relevance of accounting information. Increased voluntary
disclosure should reduce information asymmetry between managers and outside
shareholders and that this, in turn, will constrain earnings management opportunities
Corporate
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for managers. Using a simultaneous equation framework, Lobo and Zhou (2001) ?nd
evidence consistent with this hypothesis. Gul and Leung (2004) show that ?rms
characterised by CEO duality (CEO is also the Chairman of the board) provide less
voluntary disclosures compared to ?rms where these two positions are separate.
However, this relationship is weaker for ?rms with higher expert outside directors on
the board.
Based on the argument that effective corporate governance is important for good
quality ?nancial reporting, the following testable hypothesis is developed:
H1. Corporate governance is positively associated with value-relevance of
accounting information.
In Australian context, Beekes and Brown (2006) use corporate governance data from
the Horwath Report for top 250 Australian companies, and ?nd strong support for the
proposition that better-governed Australian ?rms make more informative disclosures.
They provide:
.
timeliness test; and
.
analysts’ forecast tests as measures of informativeness.
This paper differs from Beekes and Brown (2006) with respect to the measurement of
information quality. Beekes and Brown (2006) measure information quality by selected
characteristics of the disclosed information (e.g. timeliness, price discovery), whereas
the present paper uses the relationship between accounting numbers and share price as
the measure of quality according to the Ohlson (1995) model. Also, Beekes and Brown
(2006) examine a small sample of 250 ?rms for a single year. In contrast, this paper
considers a longer time span (2001-2003) and more observations and also considers the
impact of ASX Corporate Governance Best Practice Code on the changes in the
value-relevance of accounting information[7].
3. Research methodology
3.1 Valuation models
Consistent with current value-relevance research, stock price is regressed on earnings
and equity book-values to determine the association between accounting information
and share price. This level speci?cation is justi?ed as it determines whether accounting
variables re?ect information used to price shares over all periods up to a speci?c point
of time. The regression model takes the following form:
P
it
¼ b
0
þb
1
EPS
it
þb
2
BV
it
þ1
it
ð1Þ
where, P
it
is the price of a share of ?rm i at ?scal year-end. EPS
it
is the reported net
pro?t after tax (NPAT) but before abnormal items per share of ?rm i for year t. BV
it
is
the book-value per share of ?rm i at the end of year t. Although it is common in
value-relevance research to use stock price after the release of the ?nancial statements,
post-year events could add noise to the measurement process. Since this study uses a
sample of the top 500 companies, which are larger and should be closely followed by
analysts, it is expected that ?nancial statement information reaches public domain well
before the ?nancial statements are released, after the ?scal year end. Furthermore, the
disclosure of half-yearly results allows shareholders to gauge the likely annual
numbers to be reported. Therefore, the current study uses stock price at the end of the
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?scal year as the dependent variable. However, a sensitivity analysis is performed with
stock price at the end of the three months following the ?scal year-end in order to check
the robustness of the results.
3.2 Governance variables
The governance measures used in this study focus primarily on board and AC
characteristics. This choice is justi?able because the bulk of the research on the
association between corporate governance and ?nancial reporting outcomes focuses on
board and AC characteristics (Cohen et al., 2004). Furthermore, the absence of an active
market for corporate control in Australia means that anti-takeover governance
mechanisms extensively used in corporate governance research in the USA are not
relevant in the Australian context.
Corporate governance variables are de?ned as below:
.
Board independence. The general consensus in the corporate governance
literature is that the strength of corporate governance is a direct function of
board independence (Weisbach, 1988; Rosenstein and Wyatt, 1990; Dechow et al.,
1996). However, inside and af?liated directors have the specialized expertise to
make appropriate strategic choices (Fama and Jensen, 1983). Klein (1998)
concludes that the percentage of inside directors on board investment or ?nance
committees is positively associated with ?rm value. The ASX Corporate
Governance Council de?nes independent directors as those who are independent
of management and free of any business or other relationship that could
materially interfere with the exercise of their independent judgement (ASX, 2003,
p. 20). This de?nition excludes grey directors de?ned as directors having a
?duciary relationship with the ?rm by providing business services for personal
gain. Examples are lawyers, management consultants, insurance executives, and
commercial and investment bankers. Board independence is measured as the
ratio of number of independent board members to board size (BSIZE).
.
Board size. Extant research suggests that smaller boards are associated with
higher market valuation (Yermack, 1996) consistent with the notion that bene?ts
of increased monitoring by larger boards may be outweighed by poorer decision
making in larger groups (Jensen, 1993). Certo et al. (2001), however, report that
larger boards are associated with lower underpricing for ?rms undertaking an
initial public offering. Karamanou and Vafeas (2005) report that updates of
management earnings forecasts are more likely in ?rms with larger boards.
BSIZE is measured as the actual number of board members.
.
CEO duality. Corporate governance research has provided strong evidence that
separating the CEO and chairperson of the board (COB) positions is in
shareholders’ interests (Jensen, 1993; Goyal and Park, 2002). This is because if
the CEO is also COB, then he/she is more likely to strongly in?uence director
nomination and election than would be the case if these positions were separated.
However, Brickley et al. (1997) provide contrasting evidence that the costs of
separating the CEO and COB positions may exceed the bene?ts. In this paper,
CEO duality is denoted as DUAL_CEO and is coded 1 if the CEO and COB
positions are occupied by the same person, and zero otherwise.
Corporate
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AC size. In contrast to BSIZE, an AC with more members re?ects good
governance. Anderson et al. (2004) ?nd that bond yield spreads are negatively
related to AC size (ACSIZE). ACSIZE is the actual number of AC members.
.
AC independence. Prior research shows that fully independent ACs are
negatively related to earnings management (Klein, 2002; Be´dard et al., 2004).
ACIND is the ratio of independent AC members to ACSIZE.
.
AC ?nancial literacy. ASX (2003, p. 30) Corporate Governance Council
recommends companies to have AC with “members who are all ?nancially
literate (that is, be able to read and understand ?nancial statements); at least one
member should have relevant quali?cations and experience (that is should be a
quali?ed accountant or other ?nance professional with experience of ?nancial
and accounting matters) . . . ”. Empirical research supports the formation of
?nancially literate ACs. Defond et al. (2005) ?nd a positive market reaction to the
appointment of accounting ?nancial experts assigned to AC in the US context.
Measurement of AC ?nancial literacy follows the de?nition of ASX and
measured as the ratio of AC members having ?nancial literacy to the ACSIZE
and denoted as ACFL.
.
AC meeting. Abbott (2004) provides evidence that ?rms whose AC meet less than
the minimum threshold are more likely to restate earnings. There is, however, no
strict guidance as to what constitutes the ideal number of AC meetings[8]. AC
meeting is measured as the number of meetings conducted during the year and
denoted as ACMET.
.
BIG 5 audit. Empirical research has shown that high quality external auditors
proxied by Big 5/4 versus non Big 5/4 associations, result in lower levels of
abnormal accruals (Becker et al., 1998; Francis et al., 1999), lower incidence of
accounting errors (DeFond and Jiambalvo, 1991) and higher ERCs (Teoh and
Wong, 1993). Firm-year observations audited by Big 5/4 audit ?rms are coded 1,
and zero otherwise.
.
Non-audit fees. There is con?icting evidence regarding the impact of NAF on
auditor independence. Frankel et al. (2002) ?nd that high level of NAF impairs
auditor independence by allowing managers to “just meet or beat” analyst
forecast. Ashbaugh et al. (2003), however, fail to ?nd such evidence when they
adjust their discretionary accruals measure. Non-audit fees is measured as the
ratio of non-audit fees to total fees and denoted as NAF.
To measure the effect of corporate governance on the value-relevance of accounting
information, a PCA, the most common form of factor analysis, is performed to reduce
the large number of governance variables into components that account for most of the
variance in the governance variables. PCA seeks a linear combination of variables such
that the maximum variance is extracted from the variables. It then removes this
variance and seeks a second linear combination which explains the maximum
proportion of the remaining variance, and so on. It should be mentioned that the
corporate governance variables chosen for this study are a mix of metric (seven
measures) and non-metric measurements (two measures). Measures used in factor
analysis are generally assumed to be metric but non-metric measures may also be used
(Hair et al., 1998, p. 98).
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6
2
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2
0
1
6
(
P
T
)
All factors with an eigenvalue greater than unity is retained for subsequent
analysis. This results in three factors that retain about 57 per cent of the total variance
in the original data.
Panel Breports an unrotated component analysis factor matrix, while Panel Creports
a rotated (VARIMAX rotation) matrix (Table I). Three factors are named, based on the
rotated matrix solution. Factor 1 named as STRUCTURE and represents board and AC
structure with BSIZE, ACSIZE, PAFL and ACMET loading positively on this
dimension. Factor 2, named as INDEPENDENCE captures the independence dimension
of board and AC with BIND and ACIND loading positively, while DUAL_CEO loads
negatively on this dimension. ACIND loads positively in both STRUCTURE and
INDEPENDENCE dimensions, but more strongly so in the latter dimension.
Panel A: results for the extraction of component factors
Initial eigenvalues
Component Total Percentage of variance Cumulative percentage
1 2.68 29.76 29.76
2 1.31 14.60 44.35
3 1.12 12.48 56.83
Variables Components Communalities
1 2 3
Panel B: unrotated component analysis factor matrix
BIND 0.555 20.574 0.320 0.74
BSIZE 0.557 0.450 0.052 0.52
DUAL_CEO 20.424 0.530 20.284 0.54
ACSIZE 0.711 0.113 20.196 0.56
ACIND 0.764 20.267 20.058 0.66
PAFL 0.419 0.112 20.523 0.46
ACMET 0.695 0.223 20.276 0.61
BIG5 0.253 0.460 0.533 0.56
NAF 0.259 0.378 0.511 0.47
Eigenvalues 2.68 1.31 1.12 5.11
Panel C: rotated (VARIMAX rotation) component analysis factor matrix
BIND 0.087 0.855 0.053 0.74
BSIZE 0.530 20.005 0.484 0.52
DUAL_CEO 20.018 20.736 20.014 0.54
ACSIZE 0.694 0.233 0.144 0.56
ACIND 0.549 0.596 0.029 0.66
PAFL 0.652 20.053 20.185 0.46
ACMET 0.758 0.112 0.149 0.61
BIG5 0.026 0.006 0.747 0.56
NAF 0.020 0.061 0.684 0.47
Eigenvalues 2.07 1.70 1.34 5.11
Notes: BIND: equal to one if the ratio of independent outside board member (excluding grey members)
is more than 0.60 and zero otherwise; BSIZ: number of board members; DUAL_CEO: equals one if the
CEO and COB positions are occupied by the same person, zero otherwise; ACSIZE: number of AC
members; ACIND: equal to one if the AC comprises of 100 per cent independent outside AC members;
ACFL: equal to one if the ratio of AC members having ?nancial literacy is more than the median and
zero otherwise; ACMET: number of AC meetings held during the year; BIG5: equal to one if the ?rm is
audited by one of the Big 5 auditors and zero otherwise. NAF equals one if the ratio of non-audit fee
(NAF) to total fees (TFEE) is less than the median and zero otherwise Table I.
Corporate
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2
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6
(
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)
Finally, Factor 3 named as AUDITQUALITY (AQ) captures the audit quality
dimension, with Big 5 auditor and NAF (non-audit fees as a percentage of total fees)
variables loading positively on this dimension.
The factor scores from these three dimensions are used in the following regression
models to capture the effect of corporate governance on the value-relevance of earnings
and equity book values:
P
it
¼ b
0
þb
1
EPS
it
þb
2
BV
it
þb
3
STRUCTURE
it
þb
4
INDEPENDENCE
it
þb
5
AQ
it
þ1
it
ð2Þ
P
it
¼ b
0
þb
1
EPS
it
þb
2
BV
it
þb
3
STRUCTURE
it
þb
4
INDEPENDENCE
it
þb
5
AQ
it
þb
6
EPS
*
STRUCTURE
it
þb
7
EPS
*
INDEPENDENCE
it
þb
8
EPS
*
AQ
it
þb
9
BV
*
STRUCTURE
it
þb
10
BV
*
INDEPENDENCE
it
þb
11
BV
*
AQ
it
þ1
it
ð3Þ
where STRUCTURE, INDEPENDENCE and AQ are factor scores from a PCA and
coef?cients b
6
-b
8
and b
9
-b
11
are earnings and equity book values interacted with
these three factor scores, respectively. If strong corporate governance results in
value-relevant accounting information then these coef?cients should be positive and
signi?cant. However, it should be mentioned that the interaction terms in equation (3)
represent interaction between continuous variables, and therefore not amenable to
simple interpretation.
3.3 Value-relevance of accounting information and fundamental economic factors
Value-relevance of accounting information is also affected by many ?rm-speci?c
factors. To isolate the effect of corporate governance on value-relevance of accounting
information, these ?rm-speci?c factors need to be controlled in regression models.
Collins et al. (1997) ?nd that:
.
?rm pro?tability;
.
?rm size;
.
growth opportunities; and
.
?rm leverage are important fundamental variables that have an impact on the
value-relevance of accounting information.
Hayn (1995) shows that ?rms reporting negative earnings have smaller ERCs. She
argues that this is because shareholders always have the option of liquidating a ?rm
and, as a result, negative earnings are transitory in nature. Investors focus more on
book-value measure than earnings when earnings are negative (Barth et al., 1998;
Collins et al., 1997; Burgstahler and Dichev, 1997). The measure for negative earnings
used in this study is the percentage of ?rms reporting negative earnings each year.
With respect to the ?rm size variable, small companies are more likely to include
start-up companies, whose value depends on future growth potential. Moreover,
smaller ?rms are more likely to report losses than larger ?rms. Consequently, their
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:
0
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2
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2
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1
6
(
P
T
)
earnings persistence is lower, which leads to increased value relevance of book-values
than of earnings for these companies. Firm size is measured as the natural log of total
assets.
Valuation implications of accounting earnings and equity book values are expected
to be higher for high-growth ?rms. This is predicted by the fact that the value of the
?rms is composed of the book-value of equity and the present value of abnormal future
earnings (Ohlson, 1995). A ?rm with a high market-to-book ratio (high growth) is
likely to have experienced positive unexpected (abnormal) earnings in recent periods
and such earnings are expected to persist. Furthermore, a high market-to-book ratio
may be associated with positive net present value investment opportunities and
current period earnings may be used as a proxy to infer changes in market
expectations about such opportunities (Charitou et al., 2001). Finally, with respect to
?rm leverage variable, a highly leveraged ?rm has a greater degree of ?nancial and
default risks. Managers of such ?rms may therefore have an incentive to manipulate
earnings in order to avoid debt covenant violations. It could therefore be argued that,
for highly leveraged ?rms, accounting numbers should be less value-relevant for
investors. However, lenders have a vested interest in ensuring that they get the money
back from borrowers. Because ?nancial statement information provides them with a
gauge of such payback, lenders are motivated to ensure that the accounting
information they receive from borrowers free of opportunistic earnings management
practices. This could result in a positive association between accounting information
and stock price for high-leveraged ?rms. The following regression equation captures
the differential valuation implications of accounting information in the four contextual
settings described above:
P
it
¼ w
0
þw
1
EPS
it
þw
2
BV
it
þw
3
LOSS
it
þw
4
SIZE
it
þw
5
DEBT
it
þw
6
GROWTH
it
þw
7
EPS
*
LOSS
it
þw
8
EPS
*
SIZE
it
þw
9
EPS
*
DEBT
it
þw
10
EPS
*
GROWTH
it
þw
11
BV
*
LOSS
it
þw
12
BV
*
SIZE
it
þw
13
BV
*
DEBT
it
þw
14
BV
*
GROWTH
it
þ1
it
ð4Þ
All variables are de?ned as before. The coef?cient of w
7
is expected to be positive
while those of w
8
and w
10
are likely to be positive for reasons described above. No
prediction is made regarding the coef?cient of w
9
. Coef?cients of w
11
, w
12
and w
14
are
likely to be positive. Again no prediction is made regarding w
13
.
The ?nal regression re-estimates equation (3) after controlling for the effect of
fundamental economic factors. This is important because if the value-relevance of
accounting information is determined mostly by ?rm-speci?c factors then there should
be minimal or no association between governance factors and accounting information
usefulness. On the other hand, if the value-relevance of accounting information is solely
determined by the governance structure of a ?rm then the ?rm-speci?c factors will
have little or no explanatory power for share price. The following regression equation
is estimated to evaluate this hypothesis:
Corporate
governance
177
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I
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A
t
2
1
:
0
6
2
4
J
a
n
u
a
r
y
2
0
1
6
(
P
T
)
P
it
¼g
0
þg
1
EPS
it
þg
2
BV
it
þg
3
STRUCTURE
it
þg
4
INDEPENDENCE
it
þg
5
AQ
it
þg
6
EPS*STRUCTURE
it
þg
7
EPS*INDEPENDENCE
it
þg
8
EPS*AQ
it
þg
9
BV*STRUCTURE
it
þg
10
BV*INDEPENDENCE
it
þg
11
BV*AQ
it
þg
12
LOSS
it
þg
13
SIZE
it
þg
14
DEBT
it
þg
15
GROWTH
it
þg
16
EPS*LOSS
it
þg
17
EPS*SIZE
it
þg
18
EPS*DEBT
it
þg
19
EPS*GROWTH
it
þg
20
BV*LOSS
it
þg
21
BV*SIZE
it
þg
22
BV*DEBT
it
þg
23
BV*GROWTH
it
þ1
it
ð5Þ
If better corporate governance results in stronger association between accounting
information and stock price then the coef?cients g
6
to g
11
would be expected to be
positive after incorporating the effect of ?rm-speci?c economic factors.
4. Sample selection and descriptive statistics
4.1 Sample selection
The present study uses data from Australia’s top 500 listed companies for the period
2001-2003. This selection is primarily due to the prohibitive cost of collecting corporate
governance data for all the listed companies. Consistent with prior research, ?rms
belonging to banks, diversi?ed ?nancials, and insurance industries (GICS codes 4010,
4020 and 4030, respectively) are excluded from the analysis as these companies
operate in industries with different regulatory environments. Missing year-end price
information reduces the sample by ?ve observations. Negative equity values are also
eliminated because these are distress companies and should be of interest in their own
right. A further two observations are eliminated because they lack information
regarding fundamental economic factors. The ?nal sample consists of 1,289 ?rm-year
observations from 2001 to 2003 with 430, 426 and 433 ?rms, respectively.
Financial statement data and corporate governance information come from the
Aspect Financial Analysis and Connect 4 databases, respectively. The Aspect
database provides comprehensive data for all ASX listed companies whilst the Connect
4 database consists of annual reports of the top listed companies. Finally,
DATASTREAM provides stock prices of companies.
4.2 Descriptive statistics
In Table II, panel A presents descriptive statistics of the accounting variables whilst
panel B presents descriptive statistics of the corporate governance variables. Mean
(median) share price is 2.93 (1.46), respectively, with an interquartile range of 0.67 to
3.39. Mean (median) EPS is 16 (9) cents per share whilst mean (median) BV is 1.58 and
0.96 cents, respectively. About 23 per cent of sample ?rm-year observations represent
negative earnings observations. The natural log of median ?rm size is 8.35 and the
leverage ratio is 0.23. Firms in the sample are growth ?rms with median
market-to-book ratio of 1.57.
Descriptive statistics of the governance variables show that the average BSIZE is
6.29 members who meet on average 10.29 times in a year. About 57 per cent of the
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A
t
2
1
:
0
6
2
4
J
a
n
u
a
r
y
2
0
1
6
(
P
T
)
P
a
n
e
l
A
:
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c
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i
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a
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7
8
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0
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1
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0
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1
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2
0
.
2
1
B
V
1
.
5
8
0
.
9
6
2
.
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2
0
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3
6
1
.
9
5
L
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S
0
.
2
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0
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4
5
–
–
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8
.
3
5
8
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2
4
0
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3
7
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7
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3
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2
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o
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2
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2
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1
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0
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2
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6
1
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4
3
.
0
0
0
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1
5
.
0
0
D
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c
h
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m
o
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s
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r
e
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o
.
¼
1
N
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.
¼
0
P
e
r
c
e
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¼
1
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r
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¼
0
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o
a
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3
1
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5
8
0
.
5
7
0
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4
3
C
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-
C
h
a
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a
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2
2
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1
,
0
6
0
0
.
1
8
0
.
8
2
A
C
i
n
d
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p
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6
2
0
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6
9
0
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4
8
0
.
5
2
A
C
?
n
a
n
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a
l
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t
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a
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3
5
3
5
4
0
.
7
3
0
.
2
7
B
i
g
5
a
u
d
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t
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r
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I
G
5
1
,
0
7
4
2
1
5
0
.
8
3
0
.
1
7
R
a
t
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o
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f
n
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a
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d
i
t
t
o
t
o
t
a
l
f
e
e
s
N
A
F
6
4
3
6
4
6
0
.
5
0
0
.
5
0
(
c
o
n
t
i
n
u
e
d
)
Table II.
Corporate
governance
179
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Y
U
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S
I
T
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A
t
2
1
:
0
6
2
4
J
a
n
u
a
r
y
2
0
1
6
(
P
T
)
P
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:
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5
N
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1
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1
1
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1
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.
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3
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2
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2
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.
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0
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.
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Table II.
ARJ
21,2
180
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o
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n
l
o
a
d
e
d
b
y
P
O
N
D
I
C
H
E
R
R
Y
U
N
I
V
E
R
S
I
T
Y
A
t
2
1
:
0
6
2
4
J
a
n
u
a
r
y
2
0
1
6
(
P
T
)
board members are completely independent. Only 18 per cent of the sample
observations are characterised by CEO-chair duality implying that, for the majority of
the sample ?rms, CEO and board chair positions are occupied by different persons.
Average number of AC meetings is 2.96 with a median of 3.00 meetings. About
48 per cent of the sample observations are characterised by completely independent AC
members and 73 per cent of the AC members possess ?nancial literacy. Prevalence of
Big 5/4 auditing is apparent as 83 per cent of the sample observations are audited by
Big 5/4 auditors.
Panel C of Table II reports the correlation coef?cients of the corporate governance
variables. As expected, almost all of the correlation coef?cients are signi?cant at better
than 5 per cent signi?cance level. Consistent with extant research BIND and ACIND
are signi?cantly positively correlated (correlation coef?cient is 0.53). ACSIZE and
ACIND are strongly positively correlated; as are ACSIZE with ACMET and ACFL.
5. Empirical results
5.1 Basic regression result
Column two of Table III reports the pooled regression result of equation (1). Consistent
with value-relevance research, both earnings and equity book-values enter into the
regression equation with positive and statistically signi?cant coef?cients. These two
variables together explain about 50 per cent of the cross-sectional variation in stock
prices. The regression estimate includes industry and year dummies to control for
industry and year-wide effects on the value relevance of accounting information.
The earnings coef?cient of 3.29 represents a persistence coef?cient of about 0.85
following Ohlson’s (1995) accounting-based valuation framework. According to Ohlson
(1995) the coef?cient on abnormal earnings is a
1
¼ v/(R-v) where R is the discount
rate and v is the persistence coef?cient. Assuming a discount rate of 10 per cent, the
coef?cient of 3.32 translates into a persistence of about 84 per cent which can be
considered quite high for sample ?rms. The book value coef?cient of 1.31 substantially
exceeds the theoretical value of 1.00, illustrating the conservative nature of accounting
in Australia.
5.2 Corporate governance and value-relevance of accounting information
Column three of Table III presents the regression result of equation (2). This regression
equation incorporates three factor score variables along with earnings and equity book
values. Reported results reveal that both STRUCTURE and AQ variables enter into the
regression with positive and statistically signi?cant coef?cients, implying a higher
market valuation for ?rms possessing good quality governance. The adjusted R
2
of
equation (2) is 51 per cent which is not signi?cantly different from an adjusted R
2
of
50 per cent reported following equation (1). However, equation (2) does not substantiate
the interaction effect of governance variables with earnings and equity book values
that would establish the valuation implications of accounting information conditional
on corporate governance. Column four of the table addresses this following equation
(3). The adjusted R
2
of equation (3) is 57 per cent which is signi?cantly higher than
the baseline adjusted R
2
of 50 per cent (F statistics 23.19, signi?cant at better than
1 per cent level). This implies that incorporation of the interaction variables improves
the explanatory power of the regression model.
Corporate
governance
181
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C
H
E
R
R
Y
U
N
I
V
E
R
S
I
T
Y
A
t
2
1
:
0
6
2
4
J
a
n
u
a
r
y
2
0
1
6
(
P
T
)
Consistent with equation (1), coef?cients on both EPS and BV remain positive and
statistically signi?cant at better than the 1 per cent level. However, for the purpose of
this study the coef?cients of interest from equation (3) are b
6
-b
11
. If the corporate
governance structure improves the credibility of ?nancial information to market
participants, then these coef?cients should be positive and signi?cant. Effective
Variables Coef?cients t-statistics Coef?cients t-statistics Coef?cients t-statistics
Panel A: Pooled regression results
Model (1) Model (2) Model (3)
Constant 20.25 20.56 0.05 0.13 20.13 20.40
EPS 3.29
*
4.05 3.25
*
4.16 2.71
*
3.98
BV 1.31
*
8.17 1.22
*
7.19 1.21
*
9.96
STRUCTURE – – 0.43
*
2.62 20.09 20.75
INDEPENDENCE – – 0.03 0.27 20.26 21.99
AQ – – 0.36
*
4.19 0.14 1.04
EPS
*
STRUCTURE 1.71
*
2.89
EPS
*
INDEPENDENCE 0.87 1.43
EPS
*
AQ 0.07 0.13
BV
*
STRUCTURE 0.16
* * *
1.74
BV
*
INDEPENDENCE 0.11 0.99
BV
*
AQ 0.09 0.92
Year dummies
* * *
Industry dummies
* * *
Adjusted R
2
0.50 0.51 0.57
F-stat for difference in
R
2
between Models (1)
and (3) 23.19
Panel B: Yearly regression results of model (3)
2001 2002 2003
Constant 20.12 20.40 0.10 0.16 20.17 20.28
EPS 4.37
*
3.85 3.96
* *
2.53 1.29
* *
2.29
BV 0.98
*
5.62 1.06
*
5.49 1.37
*
15.59
STRUCTURE 0.29 1.46 20.05 20.37 20.31
* * *
21.98
INDEPENDENCE 0.06 0.40 20.04 20.22 20.53
*
22.96
AQ 0.00 0.01 20.23 21.17 20.01 20.06
EPS
*
STRUCTURE 1.37 1.22 1.48 1.12 2.18
*
4.94
EPS
*
INDEPENDENCE 22.22
* *
22.29 2.05 1.25 1.18
* * *
1.94
EPS
*
AQ 1.56 1.26 1.32 1.15 1.32
* *
2.06
BV
*
STRUCTURE 20.14 20.85 0.14 0.87 0.16
*
2.64
BV
*
INDEPENDENCE 0.08 0.64 20.15 20.71 0.29
*
3.70
BV
*
AQ 0.22
* *
2.04 0.29
* *
1.85 0.07 0.88
Industry dummies
* * * *
Adjusted R
2
0.52 0.59 0.69
Notes:
*
,
* *
,
* * *
Represents statistical signi?cance at 1, 5, and 10 per cent levels, respectively,
(two-tailed tests). Number of observations are 1,289 from 2001 to 2003. PRICE is the end-of-year share
price. E is the earnings per share calculated as (NPAT/share outstanding)). BV is the equity
book-value per share calculated as (shareholders’ equity/share outstanding). VARIMAX rotation
matrix procedure results in three factors scores. Factor 1 named STRUCTURE represents board and
AC structure. Factor 2 named INDEPENDENCE captures the independence dimension of board and
AC. Finally, Factor 3 named AUDITQUALITY (AQ) captures the audit quality dimension. See
equations (1)-(3) for reference
Table III.
Effect of corporate
governance on
value-relevance of
accounting information
ARJ
21,2
182
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e
d
b
y
P
O
N
D
I
C
H
E
R
R
Y
U
N
I
V
E
R
S
I
T
Y
A
t
2
1
:
0
6
2
4
J
a
n
u
a
r
y
2
0
1
6
(
P
T
)
corporate governance ensures that ?nancial information presented to outsiders re?ects
the underlying business operations and is not opportunistically biased. Regression
results from equation (3) reveal that with respect to earnings, both the STRUCTURE
and INDEPENDENCE dimensions of corporate governance have a positive and
signi?cant impact on market valuation but the AQ dimension is not signi?cantly
related. Recall that the STRUCTURE dimension captures board as well as ACSIZE, AC
meetings and AC ?nancial literacy while the INDEPENDENCE dimension captures
board and ACIND and CEO-duality. The coef?cients on EPS
*
STRUCTURE,
EPS
*
INDEPENDENCE and EPS
*
AQ are 1.71, 0.87 and 0.07, respectively.
Regarding the BV variable, reported results reveal that the coef?cient
BV
*
STRUCTURE is positive but in contrast to earnings, is marginally signi?cant.
The other two coef?cients are insigni?cant.
Governance literature provides evidence that larger boards are associated with
smaller market valuations (Yermack, 1996; Eisenberg et al., 1998). This is consistent
with the view that coordination/communication problems as well as agency problems
become more acute as a board grows larger. However, Cheng (2007) reports that larger
boards are associated with less variable operating performances. Cheng (2007) argues
that larger boards require more compromises among the members to reach consensus
and, therefore, decisions of larger boards are less extreme. From the perspective of
market participants, relatively stable accounting information is more highly valued
than volatile information. This could explain the positive effects of BSIZE on valuation
implications of earnings and book values. AC ?nancial literacy also serves to improve
?nancial reporting quality. Dhaliwal et al. (2006) ?nd a signi?cant positive relationship
between accounting experts on the AC, and accruals quality. High quality accruals are
perceived by market participants to be more credible and relevant for equity valuation.
An AC with more members in it, and more frequent meetings, may also enhance the
reporting quality. Empirical studies provide mixed evidence for the impact of ACSIZE
on ?nancial reporting quality. Some studies report no effect of ACSIZE on reporting
quality (Xie et al., 2003; Abbott, 2004), while other studies document the positive effect
of large AC on ?nancial reporting quality (Yang and Krishnan, 2005; Lin et al., 2006).
In the absence of a strong theoretical framework regarding the effect of ACSIZE and
meetings on reporting quality, the reported evidence in this paper is rather descriptive.
Independence of boards of directors as well as AC has been extensively discussed as
two of the most crucial governance mechanisms. A non-executive director who is
entirely independent from management is expected to exert strong oversight of
managerial behaviour, and offer the most protection to stakeholders. The Australian
Code of Corporate Governance also emphasises the signi?cance of having independent
board and AC members. Empirical research is also consistent with this proposition.
Beasley (1996) ?nds that the likelihood of ?nancial statement fraud decreases with
increasing numbers of independent directors. Dechow et al. (1996) show that ?rms
allegedly violating GAAP have insider-dominated boards. With respect to AC
characteristics, Klein (2002) shows that fully independent AC are negatively related to
managerial earnings management.
The AQ interaction term is positive but insigni?cant. This may be because of little
cross-sectional variation among the sample ?rms with respect to audit ?rms. As is
evident from Panel C, Table I, 83 per cent of the sample companies are audited by Big 5
auditors. With respect to the explanatory power of equation (2), the adjusted R
2
Corporate
governance
183
D
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n
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o
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d
b
y
P
O
N
D
I
C
H
E
R
R
Y
U
N
I
V
E
R
S
I
T
Y
A
t
2
1
:
0
6
2
4
J
a
n
u
a
r
y
2
0
1
6
(
P
T
)
increases to 57 per cent compared with the baseline regression of 50 per cent. This
difference in the adjusted R
2
between the two models is statistically highly signi?cant
(F value of 23.19, signi?cant at better than the 1 per cent level). Davidson et al. (2005)
also fail to ?nd any constraining effect of Big 5 auditors on income-increasing earnings
management in Australia. AQ dimension also includes an element of non-audit
services provision to clients. Over the years an extensive literature on the subject of
auditor independence has developed, and a focal point of much of this literature has
been the identi?cation of those factors which do, and do not, impact upon auditor
independence. Among all the factors identi?ed in the literature which might threaten
the independence of the auditor, the provision of non-audit services has been the
subject of the most heated debate (Canning and Gwilliam, 1999). Ruddock et al. (2005)
examine whether the provision of NAS by incumbent auditors is associated with a
reduction in the extent to which earnings re?ect bad news on a timely basis
(news-based conservatism) in Australia. The authors fail to ?nd any evidence that
increasing provision of NAS is associated with less conservative accounting.
It should be mentioned that ASX Corporate Council released the ?rst version of the
Best Practice Code in March 2003 although the Council was formed in August 2002.
The sample time frame chosen for this study (2001-2003) provides an opportunity to
examine the regulatory impact of the code on ?nancial reporting quality of listed
Australian companies. Empirical evidence regarding market perceptions of corporate
governance legislations is mixed. Barton and Waymire (2004) examine the extent to
which managers, without a regulatory mandate, supply higher quality ?nancial
reporting to mitigate investor losses during a ?nancial crisis. Using data from the 1929
USA stock market, they ?nd that contracting and control con?icts induce managers to
provide high-quality information even in the absence of regulation and that ?rms with
high-quality information suffered less during the stock market crash. Greenstone et al.
(2006), on the other hand, ?nd positive market reactions to the 1964 Securities Acts
amendments. Evidence from the recent, comprehensive governance legislation, the
Sarbanes-Oxley Act of 2002 (SOX 2002) is mixed, with Chhaochharia and Grinstein
(2007) ?nding positive market effects of the SOX 2002 on ?rm value, while Zhang
(2007) reports the opposite. Consistent with Zhang (2007), Bhattacharya et al. (2007)
?nd that CEO certi?cation mandated by SOX 2002 is not value-relevant. In Germany,
Goncharov et al. (2006) examine the value-relevance of degree of conformity to the
German Corporate Governance Code (GCGC) by German companies. They ?nd that
compliance with the GCGC is positively priced by German capital market.
To shed further light on this issue, Panel B of Table III presents yearly regression
results for corporate governance effect on value-relevance of accounting information. If
passage of the corporate governance regulation positively affects the value-relevance
of accounting information then we should expect to see a signi?cant improvement in
the explanatory power of the regression equation (3) in the post regulatory regime than
pre-regulation period. Regression result supports this proposition. The explanatory
power of regression equation (3) is signi?cantly higher in post regulation period (an
adjusted R
2
of 69 per cent in 2003 versus 59 and 52 per cent in 2002 and 2001,
respectively). With respect to six interaction coef?cients, all but BV
*
AQ are positive
and signi?cant at better than 10 per cent level.
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Taken together, empirical evidence shows that corporate governance positively
affects value-relevance of accounting information and this has become more signi?cant
after the passage of ASX Corporate Governance Best Practice Code.
5.3 Corporate governance and value-relevance of accounting information after
controlling for ?rm-speci?c economic factors
However, as previously mentioned, the value-relevance of accounting information is
quite likely to be affected by ?rm-speci?c economic factors. Table IV reports
Model 4 Model 5
Equation (4) Equation (5)
Variables Coef?cients t-statistics Coef?cients t-statistics
Constant 20.01 20.02 20.10 20.32
EPS 2.08
*
2.86 3.12
*
4.12
BV 0.53
*
3.41 0.55
*
4.97
STRUCTURE – 20.13 21.40
INDEPENDENCE – 20.03 20.36
AQ – 20.01 20.11
EPS
*
STRUCTURE – 1.00
*
3.29
EPS
*
INDEPENDENCE – 0.56
* *
2.29
EPS
*
AQ – 0.41 1.40
BV
*
STRUCTURE – 0.07
* * *
1.63
BV
*
INDEPENDENCE – 20.02 20.53
BV
*
AQ – 20.04 20.76
EPS
*
LOSS 22.65
* * *
21.84 23.58
*
25.20
EPS
*
SIZE 1.61
* *
2.03 0.20 0.29
EPS
*
DEBT 21.93
* *
21.95 21.82
*
23.43
EPS
*
GROWTH 4.06
*
3.25 3.41
*
5.75
BV
*
LOSS 0.10 0.62 0.14 1.15
BV
*
SIZE 0.31
* *
2.15 0.21 1.61
BV
*
DEBT 20.01 20.08 0.04 0.47
BV
*
GROWTH 1.06
* *
5.70 1.02
*
10.66
Year dummies
* *
Industry dummies
* *
Observations 1,289 1,289
Adjusted R
2
0.73 0.74
F-stat for difference in R
2
Model 4 vs Model1 90.52
Model 4 vs Model 5 5.5
Notes:
*
,
* *
,
* * *
Represents statistical signi?cance at 1, 5, and 10 per cent levels, respectively,
(two-tailed tests). PRICE is the end-of-year share price. E is the earnings per share calculated as
(NPAT/share outstanding)). BV is the equity book-value per share calculated as (shareholders’
equity/share outstanding). LOSS is a categorical variable taking a value of 1 for EPS less than zero and
zero otherwise. SIZE is the natural logarithm of MVE. LEVERAGE is the ratio of (short term
debt þ long-term debt/total assets). GROWTH is the ratio of MVE/BV measured at the end of the year.
VARIMAX rotation matrix procedure results in three factors scores. Factor 1 named STRUCTURE
represents board and AC structure. Factor 2 named INDEPENDENCE captures the independence
dimension of board and AC. Finally, Factor 3 named AUDITQUALITY (AQ) captures the audit
quality dimension. Coef?cient values of LOSS, SIZE, DEBT and GROWTH dummies are not reported
for the sake of brevity. See equations (4) and (5) for reference
Table IV.
Corporate governance,
value-relevance and
fundamental economic
factors
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regression results for equation (4) developed to test for such a possibility. The adjusted
R
2
reported in column two of Table IV is 73 per cent which signi?cantly higher than
the baseline regression adjusted R
2
of 50 per cent. The difference in adjusted R
2
between equation (4) and equation (1) is statistically highly signi?cant (F statistics
90.52, signi?cant at better than 1 per cent level). Incorporation of the ?rm-speci?c
economic factors signi?cantly improves the explanatory power of the regression
model. Coef?cient on EPS
*
LOSS is negative and marginally signi?cant implying that
earnings become less relevant for ?rm valuation when ?rms report losses. Regarding
?rm size, Table IV reports that both earnings and book values are positive for large
?rms. Larger ?rms are more likely to be pro?table, are more likely to have a
sophisticated internal control system for easier detection of earnings manipulations
and are more likely to be audited by big audit ?rms who constrain earnings
management (Becker et al., 1998). All these features are expected to make accounting
information more reliable and therefore, more closely associated with stock price.
Earnings of highly leveraged ?rms are negatively valued in the market, as is
evident from the negative coef?cient for EPS
*
DEBT (coef?cient value 21.93,
statistically signi?cant at the 10 per cent level, two-tailed test). A highly leveraged ?rm
has a greater degree of ?nancial and default risks. Managers of such ?rms may
therefore have an incentive to manipulate earnings in order to avoid debt covenant
violations (Defond and Jiambalvo, 1994), rendering earnings information less credible
to market participants. Regarding the growth variable, the regression result shows that
both the earnings and BV interaction coef?cients are positive and statistically
signi?cant. This seems to support the proposition that a high-growth ?rm is likely to
have experienced positive abnormal earnings in recent periods which can be expected
to persist. Also, high-growth ?rms are likely to have more positive net present value
investment opportunities, and unexpected earnings may be used as a proxy to infer
changes in market expectations about such opportunities (Charitou et al., 2001). The
adjusted R
2
of equation (4) is signi?cantly higher from the baseline regression model
represented by equation (1) (73 per cent compared to 50 per cent). The F-statistic for the
difference in adjusted R
2
between these two models is 90.52, which is statistically
highly signi?cant.
The signi?cance of these ?rm-characteristics in ?rm valuation implies that these
factors should be controlled in order to isolate the effect of corporate governance.
Model 5 in Table IV, therefore, incorporates both corporate governance and ?rm
characteristics in the same regression equation. The coef?cients and the statistical
signi?cance of the ?rm-speci?c variables are almost identical to those of model (4). Of
the governance variables, EPS
*
STRUCTURE and EPS
*
INDEPENDENCE are both
positive and statistically signi?cant at the 1 and 5 per cent levels, respectively. The
effect of governance on the valuation implication of equity book values is not so
obvious. Only BV
*
STRUCTURE is positive and signi?cant at the 10 per cent level.
The adjusted R
2
of model 5 is 74 per cent which is slightly higher than that in model 4
and F-stat for difference in adjusted R
2
between these two models is statistically
signi?cant at 5 per cent level.
The ?ndings, therefore suggest that the value-relevance of accounting information
is affected by a ?rm’s corporate governance structure as well as by ?rm-speci?c
economic factors. Interestingly, ?rm-speci?c economic factors seem to have a much
stronger impact on the value-relevance of accounting information than the ?rm’s
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corporate governance structure. This is a signi?cant contribution to the existing
value-relevance research, which examines the effects of ?rm-speci?c variables and
corporate governance structures in isolation[9]. For example, Collins et al. (1997)
document that over a long period of time the value-relevance of earnings has decreased
in the USA because of increasing ?rm size, and increasing numbers of loss-making
?rms, ?rms with one-time items, and R&D-intensive ?rms. However, they do not
consider the impact of corporate governance on the changes in the value-relevance of
accounting information.
5.4 Endogenous nature of corporate governance choice and value-relevance of
accounting information
There is a growing concern in the academic literature regarding the ?rst-order effect of
corporate governance on some outcome variables (e.g. ?rm performance, ?rm
valuation, ?nancial reporting quality). For example, Hermalin (2008) models the
relationship between governance and ?rm value assuming that ?rms that have the best
potential to perform well will lose the most if they have a poor governance structure.
Causality, according to Hermalin, therefore, runs from better performance to stronger
governance structure. Lehn et al. (2007) also report that causality runs from ?rm
valuation (proxied by market-to-book ratio) to governance structure[10]. If the
regressor variable (corporate governance structure in the present case) is assumed to
be endogenously determined, failure to include exogenous determinants of corporate
governance choices will result in correlated omitted variables problem. Standard OLS
regression will provide inconsistent parameters due to correlated omitted variables
problem. Regression equation (5) in Table IV attempts to include some of the
determinants of ?rm-level corporate governance choices in the pricing model of
accounting information and governance structures. For example, ?rm growth and size
has been shown to be exogenous determinants of corporate governance choices (Lehn
et al., 2007; Larcker et al., 2007). Reported results reveal that coef?cients on
EPS
*
STRUCTURE, EPS
*
INDEPENDENCE and BV
*
STRUCTURE are positive and
statistically signi?cant. It should be noted that standard econometric solution to
endogeneity problem is to implement some type of instrumental variables estimation
procedure. Instrumental variables should be correlated with endogenous regressors
but uncorrelated with the error term in the structural equation. However, identifying
precise instrumental variables is an extremely dif?cult task (Larcker et al., 2007).
Moreover, Larcker and Rusticus (2006) analytically show that OLS estimates provide
better parameter estimates than two-stage least square approach if the chosen
instrumental variables do not conform to standard de?nition of instrumental variables.
6. Conclusions
This paper examines the association between corporate governance attributes and the
value-relevance of accounting information. The quality of accounting information
determines the extent to which such information will map onto equity market value.
A ?rm’s corporate governance mosaic composed of the board of directors, AC
members, and institutional ownership, is a mechanism for providing high quality
accounting information by constraining managerial-earnings management activities.
In this study, a PCA is performed to reduce nine corporate governance variables into
three factors that account for about half of the variance in the governance variables.
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These factors represent board and AC structure, independence, and audit quality
dimensions, respectively. Value-relevance of accounting information is measured by
regressing stock price on earnings and equity book-values.
Regression results reveal that better corporate governance structures increase the
value-relevance of accounting information as re?ected in a positive and signi?cant
coef?cient for two of the three governance factors. The explanatory power of the
extended model also shows a signi?cant improvement when compared with the
baseline regression model where stock price is regressed on earnings and book
value variables alone. However, inferences drawn on the basis of this result would be
inappropriate, because the value relevance of earnings has also been shown to be
affected by ?rm-speci?c economic factors. A regression equation including
?rm-speci?c factors signi?cantly improves the adjusted R
2
to 73 from 50 per cent
reported in the baseline model. However, corporate governance factors continue to be
signi?cant, even when both governance and ?rm-speci?c factors are included together
in the same regression model. There is mixed evidence in the governance literature
regarding whether corporate governance provides high quality accounting information
in the market place. However, signi?cant regulatory reforms regarding corporate
governance around the world give an impression that regulators believe that
governance plays a key role in ensuring, among others, credible ?nancial reporting.
This paper provides support for such a view.
Notes
1. An accounting number is deemed to be value-relevant if it is signi?cantly related to stock
price (the measure of value) (Beaver, 2002). Value-relevance research uses (1) direct valuation
theory; and (2) inputs-to-equity valuation theory (Holthausen and Watts, 2001). Under the
direct valuation theory approach accounting, earnings and equity book-values are intended
to be highly associated with equity market value. In the alternative approach, accountants
provide information on inputs to valuation models that investors use in valuing ?rms’
equity.
2. Australia’s second largest insurer, HIH, went into provisional liquidation in March 2001 and
ultimately collapsed with a US$2 billion shortfall. In April 2001, 150 years old Harris Scarfe,
a major Australian retail chain, was placed in receivership on the grounds that it had
systematically overstated its pro?t. The high pro?le telecommunications company, One.Tel,
was placed into liquidation in May 2001, with estimated debts of A$600 million. In September
2001, Ansett, one of the two major Australian airlines collapsed. Pasminco, the Australian
mining company also went into voluntary administration in the same month (Leung and
Cooper, 2003; Parker, 2005).
3. The most signi?cant legislative response to Australian corporate crises has taken the form
of Corporate Law Economic Reform Program (CLERP). CLERP1 was issued back in 1995
and dealt with the development of high quality accounting standards. CLERP1 included the
commitment to adopt international accounting standards for ?nancial reporting periods
beginning on or after 1 January 2005. The other CLERP bills related to corporate governance
are CLERP3 on Directors’ duties and corporate governance, CLERP4 on improving takeover
regulations to promote a more competitive market and CLERP9 on addressing a number of
reforms in audit and corporate disclosures.
4. Recent value-relevance studies based on Ohlson’s (1995) model include Marquardt and
Wiedman (2004), who ?nd a signi?cant decrease (increase) in the estimated coef?cients of
net income (equity book-value) for the year of seasoned equity offerings. Ghosh et al. (2005)
?nd that ?rms which report sustained increases in earnings due to sustained growth in
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revenues, report higher earnings response coef?cients (ERCs) compared to ?rms that achieve
earnings increases by reducing costs. Kallapur and Kwan (2004) investigate the
value-relevance of acquired brand assets reported by the UK ?rms. The authors report
that managerial estimates of brand assets have signi?cant positive associations with market
value of equity.
5. Holthausen and Watts (2001) and Barth et al. (2001) survey the value-relevance research
from contrasting perspectives.
6. The empirical literature on earnings management is voluminous. For reviews see Healy and
Wahlen (1999), McNichols (2000) and Fields et al. (2001).
7. Recent studies have started investigating a broader set of outcome measures in?uenced by
corporate governance structures. Ajinkya et al. (2005) and Karamanou and Vafeas (2005)
report that ?rms with more outside directors and greater institutional ownership are more
likely to issue management forecasts and these forecasts appear to be more speci?c, accurate
and less optimistically biased. Byard et al. (2006) ?nd that quality of ?nancial analysts’
information about forthcoming earnings increases with the quality of corporate governance.
Vafeas (2000) reports that ?rms with smaller boards in the sample are perceived by market
participants as being more informative compared to ?rms with larger boards. However,
Vafeas ?nds no evidence that strong outside board representation improves the
return–earnings relationship.
8. ASX (2003, p. 31), for example, states that “audit committees should meet often enough to
undertake its role effectively.”
9. Vafeas (2000), however, controls for the known determinants of the ERCs like size, leverage,
negative earnings, beta, and insider ownership in a regression of market-adjusted returns on
earnings interacted with board size and board independence dummies. His focus on board
size and board independence as the only governance variables, however, masks the
value-enhancing function of audit committees.
10. Speci?cally, Lehn et al. (2007, p. 927) propose that “. . . ?rms with low market-to-book ratios
may be poorly run and, hence, more likely to be targets of control contests. If so, these ?rms
are more likely than other ?rms to adopt takeover defenses that affect the value of their
governance indices. [Another explanation is] ?rms with low market-to-book ratios are likely
to have fewer growth opportunities as compared with other ?rms. [If] low growth ?rms are
more likely to be targets of takeovers than other ?rms, these ?rms are more likely to adopt
takeover defenses as well.”
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Economics, Vol. 31, pp. 105-231.
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future earnings?”, The Accounting Review, Vol. 71, pp. 289-315.
Corresponding author
Ahsan Habib can be contacted at: [email protected]
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This article has been cited by:
1. Vera Ogeh Fiador. 2013. Corporate governance and value relevance of financial information: evidence from
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2. Panagiotis Dimitropoulos. 2011. Corporate Governance and Earnings Management in the European
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doc_325789735.pdf
This paper seeks to examine the relationship between corporate governance and the
value-relevance of accounting information in Australia
Accounting Research Journal
Corporate governance and the value-relevance of accounting information: Evidence
from Australia
Ahsan Habib Istiaq Azim
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Marion Hutchinson, (2009),"Governance issues in accounting", Accounting Research J ournal, Vol. 22 Iss 2
pp. 89-92 http://dx.doi.org/10.1108/10309610910987466
Raghavan J . Iyengar, J udy Land, Ernest M. Zampelli, (2010),"Does board governance improve
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Corporate governance
and the value-relevance
of accounting information
Evidence from Australia
Ahsan Habib
Department of Accounting, School of Business,
Auckland University of Technology, Auckland, New Zealand, and
Istiaq Azim
Division of Business, School of Commerce, University of South Australia,
Adelaide, Australia
Abstract
Purpose – This paper seeks to examine the relationship between corporate governance and the
value-relevance of accounting information in Australia.
Design/methodology/approach – This paper uses board, audit committee and external audit
related variables to proxy for corporate governance. Value-relevance is measured by the adjusted R
2
derived from a regression of stock price on earnings and equity book values following Ohlosn’s
accounting-based valuation framework.
Findings – Regression results show that ?rms with strong governance structure exhibit higher
value-relevance of accounting information. Results further show that ?rm-speci?c economic variables
are important determinants of the value-relevance of accounting information.
Research limitations/implications – Signi?cant regulatory reforms regarding corporate
governance around the world give an impression that regulators believe that governance plays a
key role in ensuring, among others, credible ?nancial reporting. This paper provides support for such
a view in Australian context.
Originality/value – This paper uses the relationship between accounting numbers and share price
as the measure of accounting information quality and also considers the impact of ASX Corporate
Governance Best Practice Code on the changes in the value-relevance of accounting information.
Keywords Corporate governance, Accounting, Accounting information, Australia
Paper type Research paper
1. Introduction
This paper examines the relationship between corporate governance structure and the
value-relevance of accounting information in Australia. The recent spate of corporate
collapses around the world has put signi?cant pressure on policy makers and
corporate management to initiate and implement good corporate governance practices.
Australia experienced some signi?cant corporate crises in 2001 with big companies
like HIH Insurance, One.Tel and Harris Scarfe going into liquidation. In August 2002,
the Australian Stock Exchange (ASX, 2003) formed the ASX Corporate Governance
The current issue and full text archive of this journal is available at
www.emeraldinsight.com/1030-9616.htm
The authors appreciate helpful comments from an anonymous review and participants of the
2006 AFAANZ conference in Wellington. They are responsible for all errors.
Corporate
governance
167
Accounting Research Journal
Vol. 21 No. 2, 2008
pp. 167-194
qEmerald Group Publishing Limited
1030-9616
DOI 10.1108/10309610810905944
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Council consisting of 21 constituencies, to develop recommendations for Australian
?rms that re?ect international best practice in corporate governance. ASX developed a
“principles of good corporate governance practice” code in 2002. ASX categorised
corporate governance practices into the following:
.
solid foundations for management and oversight;
.
value-enhancing board structure;
.
ethical and responsible decision-making campaigns;
.
ensuring integrity in ?nancial reporting;
.
making timely and balanced disclosures;
.
respecting the rights of shareholders;
.
recognising and managing risk;
.
encouraging enhanced performance;
.
executive remuneration that aligns interest of the executives with those of the
shareholders; and
.
recognising the legitimate interests of stakeholders.
The Council expects good corporate governance structures to create value by
providing value-relevant accounting information in the marketplace (Koh et al., 2007)
This paper tests that proposition by examining the relationship between governance
structures and the value-relevance of accounting information[1] in the Australian stock
market.
The Australian corporate system offers a unique environment for assessing the
impact of corporate governance mechanisms on the value of ?rms. Australian ?rms,
unlike those of Germany or Japan, have board structures and mechanisms that are
typically Anglo-Saxon in design. However, the Australian market for corporate control
is not as active as in the USA and the UK, and its effectiveness in inducing boards to
monitor closely, and take corrective action in cases of failure, might not be comparable.
This makes the role of internal governance mechanisms such as independent boards,
and audit committees (AC) more important. Furthermore, recent corporate collapses
experienced by Australia[2], albeit smaller in magnitude than those in the USA, like
ENRON and WORLD.COM, have still prompted policy makers to tighten corporate
governance regulations[3].
From an academic perspective, corporate governance is an extensively researched
area in the literature on accounting (Cohen et al., 2004). However, the impact of
corporate governance on the value-relevance of accounting information remains
unexplored. Agency theory arguments support the view that better structured
governance mechanisms should result in better quality ?nancial reporting in the
marketplace. The separation of ownership and control gives rise to information
asymmetries that managers could use to exploit outside atomistic shareholders (Berle
and Means, 1932; Jensen and Meckling, 1976). Shareholders demand ?nancial reporting
from managers in order to evaluate the performance of managers. However, in the
absence of strong monitoring mechanisms on managerial behaviour, managers could
mislead outsiders by providing ?nancial information which does not portray the true
underlying performance of the business. In such cases, accounting information is of
little use in valuing companies, and no association between market price and
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accounting information would be expected. Corporate governance mechanisms are
assumed to constrain management opportunistic earnings behaviour and,
consequently, to make accounting information more credible and relevant to outsiders.
The role of accounting numbers in company valuation is of fundamental interest to
analysts, investors and researchers alike. Prior work on the value-relevance of
accounting information has demonstrated that both income statement and balance
sheet information are useful in determining equity values (Collins et al., 1997; Francis
and Schipper, 1999). Much of the accounting-based valuation has focused on analysing
historical and forecasted accounting numbers (Richardson and Tinaikar, 2004). The
work of Ohlson (1995) and Feltham and Ohlson (1995) have produced considerable
interest amongst researchers about the role of historical accounting numbers in
valuation. Ohlson (1995) links earnings, equity book values, dividend and other
relevant information to stock price by integrating the dividend discount model, clean
surplus equation and linear information dynamics[4]. This paper utilises Ohlson’s
(1995) valuation framework to test the impact of corporate governance on the
value-relevance of accounting information.
This paper hypothesises that accounting information will be more strongly
associated with market price for ?rms with strong governance structures. This is
because managers of such ?rms will have fewer opportunities to engage in earnings
management due to strict monitoring exerted by an independent board and AC, two of
the most important corporate governance mechanisms. Klein (2002) for example, ?nds
that managers report less income-increasing accruals when the AC and board are
dominated by external independent directors. Value-relevance of accounting
information, however, is also affected by ?rm-speci?c factors and it is important to
control such variables in order to isolate the corporate governance effect on the
value-relevance of accounting information. Following extant literature (Collins et al.,
1997), four such variables are included in this study, namely:
(1) negative earnings;
(2) ?rm size;
(3) growth opportunities available to the ?rm; and
(4) ?rm leverage.
Corporate governance data used in the subsequent analysis is collected from the
annual reports of the top 500 Australian companies for 2001-2003. A principal
component analysis (PCA) is performed to reduce the large number of corporate
governance variables into three factors: the ?rst representing board and AC
composition; the second, board and AC independence (ACIND); and the third, audit
quality characteristics. Value-relevance of accounting information is measured as the
adjusted R
2
from a regression of stock price on earnings and equity book-values.
Empirical results reveal that strong corporate governance structures increase the
value-relevance of accounting information. This result holds after controlling for the
?rm-speci?c factors hypothesised to affect the value-relevance of earnings.
The paper proceeds as follows. Section 2 discusses the theoretical framework and
surveys the related literature. Section 3 describes the research methodology used in the
study. Sample selection procedure and descriptive statistics are described in Section 4.
Section 5 presents the substantive test results, and Section 6 concludes.
Corporate
governance
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2. Theoretical framework and survey of the related literature
An accounting amount is de?ned as value relevant if it has a predicted association with
equity market values (Barth et al., 2001). Financial Accounting Standards Board (1984)
Conceptual Framework speci?es relevance and reliability as the two primary criteria
for choosing among accounting alternatives. Statement of Financial Accounting
Concept (SFAC No. 5) proposes that an accounting amount will be considered relevant
if it is capable of making a difference to ?nancial statement users’ decisions. Barth et al.
(2001, p. 80) note that:
[. . .] an accounting amount will be value relevant, i.e. have a predicted signi?cant relation
with share prices, only if the amount re?ects information relevant to investors in valuing the
?rm and is measured reliably enough to be re?ected in share prices.
An extensive body of market-based accounting research (MBAR) tests for relevance of
accounting information by investigating the association of such information with
equity prices (Ball and Brown, 1968 is the pioneering study)[5]. MBAR research relied
on earnings, or a component of earnings, as explanatory variables for security returns.
This is logical, because the valuation theory has long posited a relationship between
earnings and the value of common stock (Miller and Modigliani, 1961; Graham et al.,
1962). Subsequent analytical work by Ohlson (1995) includes another valuation
construct, book value of equity, along with earnings in tests of market pricing of
accounting information. The rationale for such inclusion is premised on the
assumption that book value of equity is a proxy for the present value of expected
future normal earnings, which equals beginning of year book value multiplied by the
cost of capital. Another argument for supporting the valuation relevance of book value
of equity is that it re?ects a ?rm’s liquidation or abandonment value (Berger et al.,
1996; Burgstahler and Dichev, 1997; Barth et al., 1998). Collins et al. (1999) provide
evidence that equity book value acts both as a proxy for expected future normal
earnings and adaptation/liquidation value. Value-relevant accounting information
represents a desirable attribute of ?nancial reporting quality. Support for the
value-relevance of earnings comes from studies of the ERCs (Kormendi and Lipe, 1987;
Collins and Kothari, 1989; Easton and Harris, 1991).
Much accounting-based valuation has focused on analysing historical and
forecasted accounting numbers (Richardson and Tinaikar, 2004). The work of
Ohlson (1995) and Feltham and Ohlson (1995, 1996) has produced considerable interest
amongst researchers about the role of historical accounting numbers in valuation. The
attractiveness of the Ohlson model (OM) to empirical researchers is that it provides a
testable pricing equation that identi?es the roles of accounting and non-accounting
information, incorporating abnormal earnings, equity book values and “other
information” variables (Lo and Lys, 2000). Lo and Lys also identify other reasons for
the popularity of OM, in particular, the high R
2
achieved in most OM studies. This
provides a satisfactory response to Lev’s (1989) dismal ?ndings of very low correlation
between return and earnings. This high R
2
also suggests that “little value relevance is
related to variables other than book value of equity, net income and dividends” (p. 338).
Finally, the very high-explanatory power of the model leads researchers to conclude
that the OM can be used for policy recommendations.
However, managerial incentives to maximise their personal wealth could lead them
to provide biased accounting information to outside investors. Separation of ownership
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and control gives rise to information asymmetries between managers and outside
shareholders (Berle and Means, 1932; Jensen and Meckling, 1976) which provides
incentives to the managers to supply biased ?nancial information with the intent of
exploiting outside shareholders. Empirical evidence suggests that resource
mis-allocation can occur when investors fail to detect such biased reporting. For
example, Beneish (1997) ?nds some evidence of signi?cant abnormal returns from a
trading strategy based on an opportunistic generally accepted accounting principles
(GAAP) violation. To minimise sub-optimal managerial actions resulting in resource
mis-allocation, researchers have identi?ed a number of pure market forces, such as
product market competition (Alchian, 1950), the market for corporate control (Manne,
1965), and labour market pressure (Fama, 1980). However, despite these market forces,
there remains residual demand for additional governance measures, including boards
of directors, AC, ownership structures, etc. This demand is documented in the large
body of corporate governance research (Shleifer and Vishny, 1997; Bushman and
Smith, 2001; Denis and McConnell, 2003; Hermalin and Weisbach, 2003; Cohen et al.,
2004). From a ?nancial reporting perspective, a desirable consequence of corporate
governance is hypothesised to be the provision of high-quality accounting information
to ?nancial statement user groups. This may occur through at least two channels.
Firstly, corporate governance should provide high-quality accounting information
by curbing opportunistic earnings management practices of managers. An extensive
body of empirical literature documents the existence of opportunistic earnings
management[6]. When mangers manage earnings for opportunistic purposes,
accounting earnings become a less reliable measure of a ?rm’s ?nancial
performance. An effective corporate governance system ensures the provision of
credible accounting information to ?nancial statement user groups by constraining
opportunistic earnings management by managers. Corporate governance also helps
investors by aligning the interest of managers with the interests of shareholders and
enhancing the reliability of ?nancial information and the integrity of the ?nancial
reporting process (Watts and Zimmerman, 1986). Empirically, Klein (2002) ?nds a
negative relationship between AC- and board-independence and abnormal accruals.
Davidson et al. (2005) show that two of the corporate governance attributes, namely, a
majority of non-executive directors on the board and on the AC are negatively
associated with the likelihood of earnings management in Australia. Larcker et al.
(2007), on the other hand, ?nd that a comprehensive set of different governance
measures explains only 0.6-5.1 per cent of the cross-sectional variation of the dependent
variables, like abnormal accruals, Tobin’s Q, accounting restatements, etc. Larcker et al.
(2007) attribute the failure to ?nd any consistent relationship between corporate
governance measures and organizational performance to the dif?culty in generating
reliable and valid measures for the corporate governance construct. Brown and Caylor
(2006) ?nd support for the positive role of corporate governance measures in
value-creation based on a composite governance measure of 52 variables. Brown and
Caylor (2006) also show that the two most important governance categories are the
board of directors, and executive and director remuneration.
Secondly, the interaction between corporate governance and corporate disclosures
could also affect the value-relevance of accounting information. Increased voluntary
disclosure should reduce information asymmetry between managers and outside
shareholders and that this, in turn, will constrain earnings management opportunities
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for managers. Using a simultaneous equation framework, Lobo and Zhou (2001) ?nd
evidence consistent with this hypothesis. Gul and Leung (2004) show that ?rms
characterised by CEO duality (CEO is also the Chairman of the board) provide less
voluntary disclosures compared to ?rms where these two positions are separate.
However, this relationship is weaker for ?rms with higher expert outside directors on
the board.
Based on the argument that effective corporate governance is important for good
quality ?nancial reporting, the following testable hypothesis is developed:
H1. Corporate governance is positively associated with value-relevance of
accounting information.
In Australian context, Beekes and Brown (2006) use corporate governance data from
the Horwath Report for top 250 Australian companies, and ?nd strong support for the
proposition that better-governed Australian ?rms make more informative disclosures.
They provide:
.
timeliness test; and
.
analysts’ forecast tests as measures of informativeness.
This paper differs from Beekes and Brown (2006) with respect to the measurement of
information quality. Beekes and Brown (2006) measure information quality by selected
characteristics of the disclosed information (e.g. timeliness, price discovery), whereas
the present paper uses the relationship between accounting numbers and share price as
the measure of quality according to the Ohlson (1995) model. Also, Beekes and Brown
(2006) examine a small sample of 250 ?rms for a single year. In contrast, this paper
considers a longer time span (2001-2003) and more observations and also considers the
impact of ASX Corporate Governance Best Practice Code on the changes in the
value-relevance of accounting information[7].
3. Research methodology
3.1 Valuation models
Consistent with current value-relevance research, stock price is regressed on earnings
and equity book-values to determine the association between accounting information
and share price. This level speci?cation is justi?ed as it determines whether accounting
variables re?ect information used to price shares over all periods up to a speci?c point
of time. The regression model takes the following form:
P
it
¼ b
0
þb
1
EPS
it
þb
2
BV
it
þ1
it
ð1Þ
where, P
it
is the price of a share of ?rm i at ?scal year-end. EPS
it
is the reported net
pro?t after tax (NPAT) but before abnormal items per share of ?rm i for year t. BV
it
is
the book-value per share of ?rm i at the end of year t. Although it is common in
value-relevance research to use stock price after the release of the ?nancial statements,
post-year events could add noise to the measurement process. Since this study uses a
sample of the top 500 companies, which are larger and should be closely followed by
analysts, it is expected that ?nancial statement information reaches public domain well
before the ?nancial statements are released, after the ?scal year end. Furthermore, the
disclosure of half-yearly results allows shareholders to gauge the likely annual
numbers to be reported. Therefore, the current study uses stock price at the end of the
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?scal year as the dependent variable. However, a sensitivity analysis is performed with
stock price at the end of the three months following the ?scal year-end in order to check
the robustness of the results.
3.2 Governance variables
The governance measures used in this study focus primarily on board and AC
characteristics. This choice is justi?able because the bulk of the research on the
association between corporate governance and ?nancial reporting outcomes focuses on
board and AC characteristics (Cohen et al., 2004). Furthermore, the absence of an active
market for corporate control in Australia means that anti-takeover governance
mechanisms extensively used in corporate governance research in the USA are not
relevant in the Australian context.
Corporate governance variables are de?ned as below:
.
Board independence. The general consensus in the corporate governance
literature is that the strength of corporate governance is a direct function of
board independence (Weisbach, 1988; Rosenstein and Wyatt, 1990; Dechow et al.,
1996). However, inside and af?liated directors have the specialized expertise to
make appropriate strategic choices (Fama and Jensen, 1983). Klein (1998)
concludes that the percentage of inside directors on board investment or ?nance
committees is positively associated with ?rm value. The ASX Corporate
Governance Council de?nes independent directors as those who are independent
of management and free of any business or other relationship that could
materially interfere with the exercise of their independent judgement (ASX, 2003,
p. 20). This de?nition excludes grey directors de?ned as directors having a
?duciary relationship with the ?rm by providing business services for personal
gain. Examples are lawyers, management consultants, insurance executives, and
commercial and investment bankers. Board independence is measured as the
ratio of number of independent board members to board size (BSIZE).
.
Board size. Extant research suggests that smaller boards are associated with
higher market valuation (Yermack, 1996) consistent with the notion that bene?ts
of increased monitoring by larger boards may be outweighed by poorer decision
making in larger groups (Jensen, 1993). Certo et al. (2001), however, report that
larger boards are associated with lower underpricing for ?rms undertaking an
initial public offering. Karamanou and Vafeas (2005) report that updates of
management earnings forecasts are more likely in ?rms with larger boards.
BSIZE is measured as the actual number of board members.
.
CEO duality. Corporate governance research has provided strong evidence that
separating the CEO and chairperson of the board (COB) positions is in
shareholders’ interests (Jensen, 1993; Goyal and Park, 2002). This is because if
the CEO is also COB, then he/she is more likely to strongly in?uence director
nomination and election than would be the case if these positions were separated.
However, Brickley et al. (1997) provide contrasting evidence that the costs of
separating the CEO and COB positions may exceed the bene?ts. In this paper,
CEO duality is denoted as DUAL_CEO and is coded 1 if the CEO and COB
positions are occupied by the same person, and zero otherwise.
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AC size. In contrast to BSIZE, an AC with more members re?ects good
governance. Anderson et al. (2004) ?nd that bond yield spreads are negatively
related to AC size (ACSIZE). ACSIZE is the actual number of AC members.
.
AC independence. Prior research shows that fully independent ACs are
negatively related to earnings management (Klein, 2002; Be´dard et al., 2004).
ACIND is the ratio of independent AC members to ACSIZE.
.
AC ?nancial literacy. ASX (2003, p. 30) Corporate Governance Council
recommends companies to have AC with “members who are all ?nancially
literate (that is, be able to read and understand ?nancial statements); at least one
member should have relevant quali?cations and experience (that is should be a
quali?ed accountant or other ?nance professional with experience of ?nancial
and accounting matters) . . . ”. Empirical research supports the formation of
?nancially literate ACs. Defond et al. (2005) ?nd a positive market reaction to the
appointment of accounting ?nancial experts assigned to AC in the US context.
Measurement of AC ?nancial literacy follows the de?nition of ASX and
measured as the ratio of AC members having ?nancial literacy to the ACSIZE
and denoted as ACFL.
.
AC meeting. Abbott (2004) provides evidence that ?rms whose AC meet less than
the minimum threshold are more likely to restate earnings. There is, however, no
strict guidance as to what constitutes the ideal number of AC meetings[8]. AC
meeting is measured as the number of meetings conducted during the year and
denoted as ACMET.
.
BIG 5 audit. Empirical research has shown that high quality external auditors
proxied by Big 5/4 versus non Big 5/4 associations, result in lower levels of
abnormal accruals (Becker et al., 1998; Francis et al., 1999), lower incidence of
accounting errors (DeFond and Jiambalvo, 1991) and higher ERCs (Teoh and
Wong, 1993). Firm-year observations audited by Big 5/4 audit ?rms are coded 1,
and zero otherwise.
.
Non-audit fees. There is con?icting evidence regarding the impact of NAF on
auditor independence. Frankel et al. (2002) ?nd that high level of NAF impairs
auditor independence by allowing managers to “just meet or beat” analyst
forecast. Ashbaugh et al. (2003), however, fail to ?nd such evidence when they
adjust their discretionary accruals measure. Non-audit fees is measured as the
ratio of non-audit fees to total fees and denoted as NAF.
To measure the effect of corporate governance on the value-relevance of accounting
information, a PCA, the most common form of factor analysis, is performed to reduce
the large number of governance variables into components that account for most of the
variance in the governance variables. PCA seeks a linear combination of variables such
that the maximum variance is extracted from the variables. It then removes this
variance and seeks a second linear combination which explains the maximum
proportion of the remaining variance, and so on. It should be mentioned that the
corporate governance variables chosen for this study are a mix of metric (seven
measures) and non-metric measurements (two measures). Measures used in factor
analysis are generally assumed to be metric but non-metric measures may also be used
(Hair et al., 1998, p. 98).
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All factors with an eigenvalue greater than unity is retained for subsequent
analysis. This results in three factors that retain about 57 per cent of the total variance
in the original data.
Panel Breports an unrotated component analysis factor matrix, while Panel Creports
a rotated (VARIMAX rotation) matrix (Table I). Three factors are named, based on the
rotated matrix solution. Factor 1 named as STRUCTURE and represents board and AC
structure with BSIZE, ACSIZE, PAFL and ACMET loading positively on this
dimension. Factor 2, named as INDEPENDENCE captures the independence dimension
of board and AC with BIND and ACIND loading positively, while DUAL_CEO loads
negatively on this dimension. ACIND loads positively in both STRUCTURE and
INDEPENDENCE dimensions, but more strongly so in the latter dimension.
Panel A: results for the extraction of component factors
Initial eigenvalues
Component Total Percentage of variance Cumulative percentage
1 2.68 29.76 29.76
2 1.31 14.60 44.35
3 1.12 12.48 56.83
Variables Components Communalities
1 2 3
Panel B: unrotated component analysis factor matrix
BIND 0.555 20.574 0.320 0.74
BSIZE 0.557 0.450 0.052 0.52
DUAL_CEO 20.424 0.530 20.284 0.54
ACSIZE 0.711 0.113 20.196 0.56
ACIND 0.764 20.267 20.058 0.66
PAFL 0.419 0.112 20.523 0.46
ACMET 0.695 0.223 20.276 0.61
BIG5 0.253 0.460 0.533 0.56
NAF 0.259 0.378 0.511 0.47
Eigenvalues 2.68 1.31 1.12 5.11
Panel C: rotated (VARIMAX rotation) component analysis factor matrix
BIND 0.087 0.855 0.053 0.74
BSIZE 0.530 20.005 0.484 0.52
DUAL_CEO 20.018 20.736 20.014 0.54
ACSIZE 0.694 0.233 0.144 0.56
ACIND 0.549 0.596 0.029 0.66
PAFL 0.652 20.053 20.185 0.46
ACMET 0.758 0.112 0.149 0.61
BIG5 0.026 0.006 0.747 0.56
NAF 0.020 0.061 0.684 0.47
Eigenvalues 2.07 1.70 1.34 5.11
Notes: BIND: equal to one if the ratio of independent outside board member (excluding grey members)
is more than 0.60 and zero otherwise; BSIZ: number of board members; DUAL_CEO: equals one if the
CEO and COB positions are occupied by the same person, zero otherwise; ACSIZE: number of AC
members; ACIND: equal to one if the AC comprises of 100 per cent independent outside AC members;
ACFL: equal to one if the ratio of AC members having ?nancial literacy is more than the median and
zero otherwise; ACMET: number of AC meetings held during the year; BIG5: equal to one if the ?rm is
audited by one of the Big 5 auditors and zero otherwise. NAF equals one if the ratio of non-audit fee
(NAF) to total fees (TFEE) is less than the median and zero otherwise Table I.
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Finally, Factor 3 named as AUDITQUALITY (AQ) captures the audit quality
dimension, with Big 5 auditor and NAF (non-audit fees as a percentage of total fees)
variables loading positively on this dimension.
The factor scores from these three dimensions are used in the following regression
models to capture the effect of corporate governance on the value-relevance of earnings
and equity book values:
P
it
¼ b
0
þb
1
EPS
it
þb
2
BV
it
þb
3
STRUCTURE
it
þb
4
INDEPENDENCE
it
þb
5
AQ
it
þ1
it
ð2Þ
P
it
¼ b
0
þb
1
EPS
it
þb
2
BV
it
þb
3
STRUCTURE
it
þb
4
INDEPENDENCE
it
þb
5
AQ
it
þb
6
EPS
*
STRUCTURE
it
þb
7
EPS
*
INDEPENDENCE
it
þb
8
EPS
*
AQ
it
þb
9
BV
*
STRUCTURE
it
þb
10
BV
*
INDEPENDENCE
it
þb
11
BV
*
AQ
it
þ1
it
ð3Þ
where STRUCTURE, INDEPENDENCE and AQ are factor scores from a PCA and
coef?cients b
6
-b
8
and b
9
-b
11
are earnings and equity book values interacted with
these three factor scores, respectively. If strong corporate governance results in
value-relevant accounting information then these coef?cients should be positive and
signi?cant. However, it should be mentioned that the interaction terms in equation (3)
represent interaction between continuous variables, and therefore not amenable to
simple interpretation.
3.3 Value-relevance of accounting information and fundamental economic factors
Value-relevance of accounting information is also affected by many ?rm-speci?c
factors. To isolate the effect of corporate governance on value-relevance of accounting
information, these ?rm-speci?c factors need to be controlled in regression models.
Collins et al. (1997) ?nd that:
.
?rm pro?tability;
.
?rm size;
.
growth opportunities; and
.
?rm leverage are important fundamental variables that have an impact on the
value-relevance of accounting information.
Hayn (1995) shows that ?rms reporting negative earnings have smaller ERCs. She
argues that this is because shareholders always have the option of liquidating a ?rm
and, as a result, negative earnings are transitory in nature. Investors focus more on
book-value measure than earnings when earnings are negative (Barth et al., 1998;
Collins et al., 1997; Burgstahler and Dichev, 1997). The measure for negative earnings
used in this study is the percentage of ?rms reporting negative earnings each year.
With respect to the ?rm size variable, small companies are more likely to include
start-up companies, whose value depends on future growth potential. Moreover,
smaller ?rms are more likely to report losses than larger ?rms. Consequently, their
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earnings persistence is lower, which leads to increased value relevance of book-values
than of earnings for these companies. Firm size is measured as the natural log of total
assets.
Valuation implications of accounting earnings and equity book values are expected
to be higher for high-growth ?rms. This is predicted by the fact that the value of the
?rms is composed of the book-value of equity and the present value of abnormal future
earnings (Ohlson, 1995). A ?rm with a high market-to-book ratio (high growth) is
likely to have experienced positive unexpected (abnormal) earnings in recent periods
and such earnings are expected to persist. Furthermore, a high market-to-book ratio
may be associated with positive net present value investment opportunities and
current period earnings may be used as a proxy to infer changes in market
expectations about such opportunities (Charitou et al., 2001). Finally, with respect to
?rm leverage variable, a highly leveraged ?rm has a greater degree of ?nancial and
default risks. Managers of such ?rms may therefore have an incentive to manipulate
earnings in order to avoid debt covenant violations. It could therefore be argued that,
for highly leveraged ?rms, accounting numbers should be less value-relevant for
investors. However, lenders have a vested interest in ensuring that they get the money
back from borrowers. Because ?nancial statement information provides them with a
gauge of such payback, lenders are motivated to ensure that the accounting
information they receive from borrowers free of opportunistic earnings management
practices. This could result in a positive association between accounting information
and stock price for high-leveraged ?rms. The following regression equation captures
the differential valuation implications of accounting information in the four contextual
settings described above:
P
it
¼ w
0
þw
1
EPS
it
þw
2
BV
it
þw
3
LOSS
it
þw
4
SIZE
it
þw
5
DEBT
it
þw
6
GROWTH
it
þw
7
EPS
*
LOSS
it
þw
8
EPS
*
SIZE
it
þw
9
EPS
*
DEBT
it
þw
10
EPS
*
GROWTH
it
þw
11
BV
*
LOSS
it
þw
12
BV
*
SIZE
it
þw
13
BV
*
DEBT
it
þw
14
BV
*
GROWTH
it
þ1
it
ð4Þ
All variables are de?ned as before. The coef?cient of w
7
is expected to be positive
while those of w
8
and w
10
are likely to be positive for reasons described above. No
prediction is made regarding the coef?cient of w
9
. Coef?cients of w
11
, w
12
and w
14
are
likely to be positive. Again no prediction is made regarding w
13
.
The ?nal regression re-estimates equation (3) after controlling for the effect of
fundamental economic factors. This is important because if the value-relevance of
accounting information is determined mostly by ?rm-speci?c factors then there should
be minimal or no association between governance factors and accounting information
usefulness. On the other hand, if the value-relevance of accounting information is solely
determined by the governance structure of a ?rm then the ?rm-speci?c factors will
have little or no explanatory power for share price. The following regression equation
is estimated to evaluate this hypothesis:
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P
it
¼g
0
þg
1
EPS
it
þg
2
BV
it
þg
3
STRUCTURE
it
þg
4
INDEPENDENCE
it
þg
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it
þg
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EPS*INDEPENDENCE
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þg
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it
þg
12
LOSS
it
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SIZE
it
þg
14
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it
þg
15
GROWTH
it
þg
16
EPS*LOSS
it
þg
17
EPS*SIZE
it
þg
18
EPS*DEBT
it
þg
19
EPS*GROWTH
it
þg
20
BV*LOSS
it
þg
21
BV*SIZE
it
þg
22
BV*DEBT
it
þg
23
BV*GROWTH
it
þ1
it
ð5Þ
If better corporate governance results in stronger association between accounting
information and stock price then the coef?cients g
6
to g
11
would be expected to be
positive after incorporating the effect of ?rm-speci?c economic factors.
4. Sample selection and descriptive statistics
4.1 Sample selection
The present study uses data from Australia’s top 500 listed companies for the period
2001-2003. This selection is primarily due to the prohibitive cost of collecting corporate
governance data for all the listed companies. Consistent with prior research, ?rms
belonging to banks, diversi?ed ?nancials, and insurance industries (GICS codes 4010,
4020 and 4030, respectively) are excluded from the analysis as these companies
operate in industries with different regulatory environments. Missing year-end price
information reduces the sample by ?ve observations. Negative equity values are also
eliminated because these are distress companies and should be of interest in their own
right. A further two observations are eliminated because they lack information
regarding fundamental economic factors. The ?nal sample consists of 1,289 ?rm-year
observations from 2001 to 2003 with 430, 426 and 433 ?rms, respectively.
Financial statement data and corporate governance information come from the
Aspect Financial Analysis and Connect 4 databases, respectively. The Aspect
database provides comprehensive data for all ASX listed companies whilst the Connect
4 database consists of annual reports of the top listed companies. Finally,
DATASTREAM provides stock prices of companies.
4.2 Descriptive statistics
In Table II, panel A presents descriptive statistics of the accounting variables whilst
panel B presents descriptive statistics of the corporate governance variables. Mean
(median) share price is 2.93 (1.46), respectively, with an interquartile range of 0.67 to
3.39. Mean (median) EPS is 16 (9) cents per share whilst mean (median) BV is 1.58 and
0.96 cents, respectively. About 23 per cent of sample ?rm-year observations represent
negative earnings observations. The natural log of median ?rm size is 8.35 and the
leverage ratio is 0.23. Firms in the sample are growth ?rms with median
market-to-book ratio of 1.57.
Descriptive statistics of the governance variables show that the average BSIZE is
6.29 members who meet on average 10.29 times in a year. About 57 per cent of the
ARJ
21,2
178
D
o
w
n
l
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(
c
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)
Table II.
Corporate
governance
179
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r
w
i
s
e
Table II.
ARJ
21,2
180
D
o
w
n
l
o
a
d
e
d
b
y
P
O
N
D
I
C
H
E
R
R
Y
U
N
I
V
E
R
S
I
T
Y
A
t
2
1
:
0
6
2
4
J
a
n
u
a
r
y
2
0
1
6
(
P
T
)
board members are completely independent. Only 18 per cent of the sample
observations are characterised by CEO-chair duality implying that, for the majority of
the sample ?rms, CEO and board chair positions are occupied by different persons.
Average number of AC meetings is 2.96 with a median of 3.00 meetings. About
48 per cent of the sample observations are characterised by completely independent AC
members and 73 per cent of the AC members possess ?nancial literacy. Prevalence of
Big 5/4 auditing is apparent as 83 per cent of the sample observations are audited by
Big 5/4 auditors.
Panel C of Table II reports the correlation coef?cients of the corporate governance
variables. As expected, almost all of the correlation coef?cients are signi?cant at better
than 5 per cent signi?cance level. Consistent with extant research BIND and ACIND
are signi?cantly positively correlated (correlation coef?cient is 0.53). ACSIZE and
ACIND are strongly positively correlated; as are ACSIZE with ACMET and ACFL.
5. Empirical results
5.1 Basic regression result
Column two of Table III reports the pooled regression result of equation (1). Consistent
with value-relevance research, both earnings and equity book-values enter into the
regression equation with positive and statistically signi?cant coef?cients. These two
variables together explain about 50 per cent of the cross-sectional variation in stock
prices. The regression estimate includes industry and year dummies to control for
industry and year-wide effects on the value relevance of accounting information.
The earnings coef?cient of 3.29 represents a persistence coef?cient of about 0.85
following Ohlson’s (1995) accounting-based valuation framework. According to Ohlson
(1995) the coef?cient on abnormal earnings is a
1
¼ v/(R-v) where R is the discount
rate and v is the persistence coef?cient. Assuming a discount rate of 10 per cent, the
coef?cient of 3.32 translates into a persistence of about 84 per cent which can be
considered quite high for sample ?rms. The book value coef?cient of 1.31 substantially
exceeds the theoretical value of 1.00, illustrating the conservative nature of accounting
in Australia.
5.2 Corporate governance and value-relevance of accounting information
Column three of Table III presents the regression result of equation (2). This regression
equation incorporates three factor score variables along with earnings and equity book
values. Reported results reveal that both STRUCTURE and AQ variables enter into the
regression with positive and statistically signi?cant coef?cients, implying a higher
market valuation for ?rms possessing good quality governance. The adjusted R
2
of
equation (2) is 51 per cent which is not signi?cantly different from an adjusted R
2
of
50 per cent reported following equation (1). However, equation (2) does not substantiate
the interaction effect of governance variables with earnings and equity book values
that would establish the valuation implications of accounting information conditional
on corporate governance. Column four of the table addresses this following equation
(3). The adjusted R
2
of equation (3) is 57 per cent which is signi?cantly higher than
the baseline adjusted R
2
of 50 per cent (F statistics 23.19, signi?cant at better than
1 per cent level). This implies that incorporation of the interaction variables improves
the explanatory power of the regression model.
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Consistent with equation (1), coef?cients on both EPS and BV remain positive and
statistically signi?cant at better than the 1 per cent level. However, for the purpose of
this study the coef?cients of interest from equation (3) are b
6
-b
11
. If the corporate
governance structure improves the credibility of ?nancial information to market
participants, then these coef?cients should be positive and signi?cant. Effective
Variables Coef?cients t-statistics Coef?cients t-statistics Coef?cients t-statistics
Panel A: Pooled regression results
Model (1) Model (2) Model (3)
Constant 20.25 20.56 0.05 0.13 20.13 20.40
EPS 3.29
*
4.05 3.25
*
4.16 2.71
*
3.98
BV 1.31
*
8.17 1.22
*
7.19 1.21
*
9.96
STRUCTURE – – 0.43
*
2.62 20.09 20.75
INDEPENDENCE – – 0.03 0.27 20.26 21.99
AQ – – 0.36
*
4.19 0.14 1.04
EPS
*
STRUCTURE 1.71
*
2.89
EPS
*
INDEPENDENCE 0.87 1.43
EPS
*
AQ 0.07 0.13
BV
*
STRUCTURE 0.16
* * *
1.74
BV
*
INDEPENDENCE 0.11 0.99
BV
*
AQ 0.09 0.92
Year dummies
* * *
Industry dummies
* * *
Adjusted R
2
0.50 0.51 0.57
F-stat for difference in
R
2
between Models (1)
and (3) 23.19
Panel B: Yearly regression results of model (3)
2001 2002 2003
Constant 20.12 20.40 0.10 0.16 20.17 20.28
EPS 4.37
*
3.85 3.96
* *
2.53 1.29
* *
2.29
BV 0.98
*
5.62 1.06
*
5.49 1.37
*
15.59
STRUCTURE 0.29 1.46 20.05 20.37 20.31
* * *
21.98
INDEPENDENCE 0.06 0.40 20.04 20.22 20.53
*
22.96
AQ 0.00 0.01 20.23 21.17 20.01 20.06
EPS
*
STRUCTURE 1.37 1.22 1.48 1.12 2.18
*
4.94
EPS
*
INDEPENDENCE 22.22
* *
22.29 2.05 1.25 1.18
* * *
1.94
EPS
*
AQ 1.56 1.26 1.32 1.15 1.32
* *
2.06
BV
*
STRUCTURE 20.14 20.85 0.14 0.87 0.16
*
2.64
BV
*
INDEPENDENCE 0.08 0.64 20.15 20.71 0.29
*
3.70
BV
*
AQ 0.22
* *
2.04 0.29
* *
1.85 0.07 0.88
Industry dummies
* * * *
Adjusted R
2
0.52 0.59 0.69
Notes:
*
,
* *
,
* * *
Represents statistical signi?cance at 1, 5, and 10 per cent levels, respectively,
(two-tailed tests). Number of observations are 1,289 from 2001 to 2003. PRICE is the end-of-year share
price. E is the earnings per share calculated as (NPAT/share outstanding)). BV is the equity
book-value per share calculated as (shareholders’ equity/share outstanding). VARIMAX rotation
matrix procedure results in three factors scores. Factor 1 named STRUCTURE represents board and
AC structure. Factor 2 named INDEPENDENCE captures the independence dimension of board and
AC. Finally, Factor 3 named AUDITQUALITY (AQ) captures the audit quality dimension. See
equations (1)-(3) for reference
Table III.
Effect of corporate
governance on
value-relevance of
accounting information
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corporate governance ensures that ?nancial information presented to outsiders re?ects
the underlying business operations and is not opportunistically biased. Regression
results from equation (3) reveal that with respect to earnings, both the STRUCTURE
and INDEPENDENCE dimensions of corporate governance have a positive and
signi?cant impact on market valuation but the AQ dimension is not signi?cantly
related. Recall that the STRUCTURE dimension captures board as well as ACSIZE, AC
meetings and AC ?nancial literacy while the INDEPENDENCE dimension captures
board and ACIND and CEO-duality. The coef?cients on EPS
*
STRUCTURE,
EPS
*
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*
AQ are 1.71, 0.87 and 0.07, respectively.
Regarding the BV variable, reported results reveal that the coef?cient
BV
*
STRUCTURE is positive but in contrast to earnings, is marginally signi?cant.
The other two coef?cients are insigni?cant.
Governance literature provides evidence that larger boards are associated with
smaller market valuations (Yermack, 1996; Eisenberg et al., 1998). This is consistent
with the view that coordination/communication problems as well as agency problems
become more acute as a board grows larger. However, Cheng (2007) reports that larger
boards are associated with less variable operating performances. Cheng (2007) argues
that larger boards require more compromises among the members to reach consensus
and, therefore, decisions of larger boards are less extreme. From the perspective of
market participants, relatively stable accounting information is more highly valued
than volatile information. This could explain the positive effects of BSIZE on valuation
implications of earnings and book values. AC ?nancial literacy also serves to improve
?nancial reporting quality. Dhaliwal et al. (2006) ?nd a signi?cant positive relationship
between accounting experts on the AC, and accruals quality. High quality accruals are
perceived by market participants to be more credible and relevant for equity valuation.
An AC with more members in it, and more frequent meetings, may also enhance the
reporting quality. Empirical studies provide mixed evidence for the impact of ACSIZE
on ?nancial reporting quality. Some studies report no effect of ACSIZE on reporting
quality (Xie et al., 2003; Abbott, 2004), while other studies document the positive effect
of large AC on ?nancial reporting quality (Yang and Krishnan, 2005; Lin et al., 2006).
In the absence of a strong theoretical framework regarding the effect of ACSIZE and
meetings on reporting quality, the reported evidence in this paper is rather descriptive.
Independence of boards of directors as well as AC has been extensively discussed as
two of the most crucial governance mechanisms. A non-executive director who is
entirely independent from management is expected to exert strong oversight of
managerial behaviour, and offer the most protection to stakeholders. The Australian
Code of Corporate Governance also emphasises the signi?cance of having independent
board and AC members. Empirical research is also consistent with this proposition.
Beasley (1996) ?nds that the likelihood of ?nancial statement fraud decreases with
increasing numbers of independent directors. Dechow et al. (1996) show that ?rms
allegedly violating GAAP have insider-dominated boards. With respect to AC
characteristics, Klein (2002) shows that fully independent AC are negatively related to
managerial earnings management.
The AQ interaction term is positive but insigni?cant. This may be because of little
cross-sectional variation among the sample ?rms with respect to audit ?rms. As is
evident from Panel C, Table I, 83 per cent of the sample companies are audited by Big 5
auditors. With respect to the explanatory power of equation (2), the adjusted R
2
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increases to 57 per cent compared with the baseline regression of 50 per cent. This
difference in the adjusted R
2
between the two models is statistically highly signi?cant
(F value of 23.19, signi?cant at better than the 1 per cent level). Davidson et al. (2005)
also fail to ?nd any constraining effect of Big 5 auditors on income-increasing earnings
management in Australia. AQ dimension also includes an element of non-audit
services provision to clients. Over the years an extensive literature on the subject of
auditor independence has developed, and a focal point of much of this literature has
been the identi?cation of those factors which do, and do not, impact upon auditor
independence. Among all the factors identi?ed in the literature which might threaten
the independence of the auditor, the provision of non-audit services has been the
subject of the most heated debate (Canning and Gwilliam, 1999). Ruddock et al. (2005)
examine whether the provision of NAS by incumbent auditors is associated with a
reduction in the extent to which earnings re?ect bad news on a timely basis
(news-based conservatism) in Australia. The authors fail to ?nd any evidence that
increasing provision of NAS is associated with less conservative accounting.
It should be mentioned that ASX Corporate Council released the ?rst version of the
Best Practice Code in March 2003 although the Council was formed in August 2002.
The sample time frame chosen for this study (2001-2003) provides an opportunity to
examine the regulatory impact of the code on ?nancial reporting quality of listed
Australian companies. Empirical evidence regarding market perceptions of corporate
governance legislations is mixed. Barton and Waymire (2004) examine the extent to
which managers, without a regulatory mandate, supply higher quality ?nancial
reporting to mitigate investor losses during a ?nancial crisis. Using data from the 1929
USA stock market, they ?nd that contracting and control con?icts induce managers to
provide high-quality information even in the absence of regulation and that ?rms with
high-quality information suffered less during the stock market crash. Greenstone et al.
(2006), on the other hand, ?nd positive market reactions to the 1964 Securities Acts
amendments. Evidence from the recent, comprehensive governance legislation, the
Sarbanes-Oxley Act of 2002 (SOX 2002) is mixed, with Chhaochharia and Grinstein
(2007) ?nding positive market effects of the SOX 2002 on ?rm value, while Zhang
(2007) reports the opposite. Consistent with Zhang (2007), Bhattacharya et al. (2007)
?nd that CEO certi?cation mandated by SOX 2002 is not value-relevant. In Germany,
Goncharov et al. (2006) examine the value-relevance of degree of conformity to the
German Corporate Governance Code (GCGC) by German companies. They ?nd that
compliance with the GCGC is positively priced by German capital market.
To shed further light on this issue, Panel B of Table III presents yearly regression
results for corporate governance effect on value-relevance of accounting information. If
passage of the corporate governance regulation positively affects the value-relevance
of accounting information then we should expect to see a signi?cant improvement in
the explanatory power of the regression equation (3) in the post regulatory regime than
pre-regulation period. Regression result supports this proposition. The explanatory
power of regression equation (3) is signi?cantly higher in post regulation period (an
adjusted R
2
of 69 per cent in 2003 versus 59 and 52 per cent in 2002 and 2001,
respectively). With respect to six interaction coef?cients, all but BV
*
AQ are positive
and signi?cant at better than 10 per cent level.
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Taken together, empirical evidence shows that corporate governance positively
affects value-relevance of accounting information and this has become more signi?cant
after the passage of ASX Corporate Governance Best Practice Code.
5.3 Corporate governance and value-relevance of accounting information after
controlling for ?rm-speci?c economic factors
However, as previously mentioned, the value-relevance of accounting information is
quite likely to be affected by ?rm-speci?c economic factors. Table IV reports
Model 4 Model 5
Equation (4) Equation (5)
Variables Coef?cients t-statistics Coef?cients t-statistics
Constant 20.01 20.02 20.10 20.32
EPS 2.08
*
2.86 3.12
*
4.12
BV 0.53
*
3.41 0.55
*
4.97
STRUCTURE – 20.13 21.40
INDEPENDENCE – 20.03 20.36
AQ – 20.01 20.11
EPS
*
STRUCTURE – 1.00
*
3.29
EPS
*
INDEPENDENCE – 0.56
* *
2.29
EPS
*
AQ – 0.41 1.40
BV
*
STRUCTURE – 0.07
* * *
1.63
BV
*
INDEPENDENCE – 20.02 20.53
BV
*
AQ – 20.04 20.76
EPS
*
LOSS 22.65
* * *
21.84 23.58
*
25.20
EPS
*
SIZE 1.61
* *
2.03 0.20 0.29
EPS
*
DEBT 21.93
* *
21.95 21.82
*
23.43
EPS
*
GROWTH 4.06
*
3.25 3.41
*
5.75
BV
*
LOSS 0.10 0.62 0.14 1.15
BV
*
SIZE 0.31
* *
2.15 0.21 1.61
BV
*
DEBT 20.01 20.08 0.04 0.47
BV
*
GROWTH 1.06
* *
5.70 1.02
*
10.66
Year dummies
* *
Industry dummies
* *
Observations 1,289 1,289
Adjusted R
2
0.73 0.74
F-stat for difference in R
2
Model 4 vs Model1 90.52
Model 4 vs Model 5 5.5
Notes:
*
,
* *
,
* * *
Represents statistical signi?cance at 1, 5, and 10 per cent levels, respectively,
(two-tailed tests). PRICE is the end-of-year share price. E is the earnings per share calculated as
(NPAT/share outstanding)). BV is the equity book-value per share calculated as (shareholders’
equity/share outstanding). LOSS is a categorical variable taking a value of 1 for EPS less than zero and
zero otherwise. SIZE is the natural logarithm of MVE. LEVERAGE is the ratio of (short term
debt þ long-term debt/total assets). GROWTH is the ratio of MVE/BV measured at the end of the year.
VARIMAX rotation matrix procedure results in three factors scores. Factor 1 named STRUCTURE
represents board and AC structure. Factor 2 named INDEPENDENCE captures the independence
dimension of board and AC. Finally, Factor 3 named AUDITQUALITY (AQ) captures the audit
quality dimension. Coef?cient values of LOSS, SIZE, DEBT and GROWTH dummies are not reported
for the sake of brevity. See equations (4) and (5) for reference
Table IV.
Corporate governance,
value-relevance and
fundamental economic
factors
Corporate
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regression results for equation (4) developed to test for such a possibility. The adjusted
R
2
reported in column two of Table IV is 73 per cent which signi?cantly higher than
the baseline regression adjusted R
2
of 50 per cent. The difference in adjusted R
2
between equation (4) and equation (1) is statistically highly signi?cant (F statistics
90.52, signi?cant at better than 1 per cent level). Incorporation of the ?rm-speci?c
economic factors signi?cantly improves the explanatory power of the regression
model. Coef?cient on EPS
*
LOSS is negative and marginally signi?cant implying that
earnings become less relevant for ?rm valuation when ?rms report losses. Regarding
?rm size, Table IV reports that both earnings and book values are positive for large
?rms. Larger ?rms are more likely to be pro?table, are more likely to have a
sophisticated internal control system for easier detection of earnings manipulations
and are more likely to be audited by big audit ?rms who constrain earnings
management (Becker et al., 1998). All these features are expected to make accounting
information more reliable and therefore, more closely associated with stock price.
Earnings of highly leveraged ?rms are negatively valued in the market, as is
evident from the negative coef?cient for EPS
*
DEBT (coef?cient value 21.93,
statistically signi?cant at the 10 per cent level, two-tailed test). A highly leveraged ?rm
has a greater degree of ?nancial and default risks. Managers of such ?rms may
therefore have an incentive to manipulate earnings in order to avoid debt covenant
violations (Defond and Jiambalvo, 1994), rendering earnings information less credible
to market participants. Regarding the growth variable, the regression result shows that
both the earnings and BV interaction coef?cients are positive and statistically
signi?cant. This seems to support the proposition that a high-growth ?rm is likely to
have experienced positive abnormal earnings in recent periods which can be expected
to persist. Also, high-growth ?rms are likely to have more positive net present value
investment opportunities, and unexpected earnings may be used as a proxy to infer
changes in market expectations about such opportunities (Charitou et al., 2001). The
adjusted R
2
of equation (4) is signi?cantly higher from the baseline regression model
represented by equation (1) (73 per cent compared to 50 per cent). The F-statistic for the
difference in adjusted R
2
between these two models is 90.52, which is statistically
highly signi?cant.
The signi?cance of these ?rm-characteristics in ?rm valuation implies that these
factors should be controlled in order to isolate the effect of corporate governance.
Model 5 in Table IV, therefore, incorporates both corporate governance and ?rm
characteristics in the same regression equation. The coef?cients and the statistical
signi?cance of the ?rm-speci?c variables are almost identical to those of model (4). Of
the governance variables, EPS
*
STRUCTURE and EPS
*
INDEPENDENCE are both
positive and statistically signi?cant at the 1 and 5 per cent levels, respectively. The
effect of governance on the valuation implication of equity book values is not so
obvious. Only BV
*
STRUCTURE is positive and signi?cant at the 10 per cent level.
The adjusted R
2
of model 5 is 74 per cent which is slightly higher than that in model 4
and F-stat for difference in adjusted R
2
between these two models is statistically
signi?cant at 5 per cent level.
The ?ndings, therefore suggest that the value-relevance of accounting information
is affected by a ?rm’s corporate governance structure as well as by ?rm-speci?c
economic factors. Interestingly, ?rm-speci?c economic factors seem to have a much
stronger impact on the value-relevance of accounting information than the ?rm’s
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corporate governance structure. This is a signi?cant contribution to the existing
value-relevance research, which examines the effects of ?rm-speci?c variables and
corporate governance structures in isolation[9]. For example, Collins et al. (1997)
document that over a long period of time the value-relevance of earnings has decreased
in the USA because of increasing ?rm size, and increasing numbers of loss-making
?rms, ?rms with one-time items, and R&D-intensive ?rms. However, they do not
consider the impact of corporate governance on the changes in the value-relevance of
accounting information.
5.4 Endogenous nature of corporate governance choice and value-relevance of
accounting information
There is a growing concern in the academic literature regarding the ?rst-order effect of
corporate governance on some outcome variables (e.g. ?rm performance, ?rm
valuation, ?nancial reporting quality). For example, Hermalin (2008) models the
relationship between governance and ?rm value assuming that ?rms that have the best
potential to perform well will lose the most if they have a poor governance structure.
Causality, according to Hermalin, therefore, runs from better performance to stronger
governance structure. Lehn et al. (2007) also report that causality runs from ?rm
valuation (proxied by market-to-book ratio) to governance structure[10]. If the
regressor variable (corporate governance structure in the present case) is assumed to
be endogenously determined, failure to include exogenous determinants of corporate
governance choices will result in correlated omitted variables problem. Standard OLS
regression will provide inconsistent parameters due to correlated omitted variables
problem. Regression equation (5) in Table IV attempts to include some of the
determinants of ?rm-level corporate governance choices in the pricing model of
accounting information and governance structures. For example, ?rm growth and size
has been shown to be exogenous determinants of corporate governance choices (Lehn
et al., 2007; Larcker et al., 2007). Reported results reveal that coef?cients on
EPS
*
STRUCTURE, EPS
*
INDEPENDENCE and BV
*
STRUCTURE are positive and
statistically signi?cant. It should be noted that standard econometric solution to
endogeneity problem is to implement some type of instrumental variables estimation
procedure. Instrumental variables should be correlated with endogenous regressors
but uncorrelated with the error term in the structural equation. However, identifying
precise instrumental variables is an extremely dif?cult task (Larcker et al., 2007).
Moreover, Larcker and Rusticus (2006) analytically show that OLS estimates provide
better parameter estimates than two-stage least square approach if the chosen
instrumental variables do not conform to standard de?nition of instrumental variables.
6. Conclusions
This paper examines the association between corporate governance attributes and the
value-relevance of accounting information. The quality of accounting information
determines the extent to which such information will map onto equity market value.
A ?rm’s corporate governance mosaic composed of the board of directors, AC
members, and institutional ownership, is a mechanism for providing high quality
accounting information by constraining managerial-earnings management activities.
In this study, a PCA is performed to reduce nine corporate governance variables into
three factors that account for about half of the variance in the governance variables.
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These factors represent board and AC structure, independence, and audit quality
dimensions, respectively. Value-relevance of accounting information is measured by
regressing stock price on earnings and equity book-values.
Regression results reveal that better corporate governance structures increase the
value-relevance of accounting information as re?ected in a positive and signi?cant
coef?cient for two of the three governance factors. The explanatory power of the
extended model also shows a signi?cant improvement when compared with the
baseline regression model where stock price is regressed on earnings and book
value variables alone. However, inferences drawn on the basis of this result would be
inappropriate, because the value relevance of earnings has also been shown to be
affected by ?rm-speci?c economic factors. A regression equation including
?rm-speci?c factors signi?cantly improves the adjusted R
2
to 73 from 50 per cent
reported in the baseline model. However, corporate governance factors continue to be
signi?cant, even when both governance and ?rm-speci?c factors are included together
in the same regression model. There is mixed evidence in the governance literature
regarding whether corporate governance provides high quality accounting information
in the market place. However, signi?cant regulatory reforms regarding corporate
governance around the world give an impression that regulators believe that
governance plays a key role in ensuring, among others, credible ?nancial reporting.
This paper provides support for such a view.
Notes
1. An accounting number is deemed to be value-relevant if it is signi?cantly related to stock
price (the measure of value) (Beaver, 2002). Value-relevance research uses (1) direct valuation
theory; and (2) inputs-to-equity valuation theory (Holthausen and Watts, 2001). Under the
direct valuation theory approach accounting, earnings and equity book-values are intended
to be highly associated with equity market value. In the alternative approach, accountants
provide information on inputs to valuation models that investors use in valuing ?rms’
equity.
2. Australia’s second largest insurer, HIH, went into provisional liquidation in March 2001 and
ultimately collapsed with a US$2 billion shortfall. In April 2001, 150 years old Harris Scarfe,
a major Australian retail chain, was placed in receivership on the grounds that it had
systematically overstated its pro?t. The high pro?le telecommunications company, One.Tel,
was placed into liquidation in May 2001, with estimated debts of A$600 million. In September
2001, Ansett, one of the two major Australian airlines collapsed. Pasminco, the Australian
mining company also went into voluntary administration in the same month (Leung and
Cooper, 2003; Parker, 2005).
3. The most signi?cant legislative response to Australian corporate crises has taken the form
of Corporate Law Economic Reform Program (CLERP). CLERP1 was issued back in 1995
and dealt with the development of high quality accounting standards. CLERP1 included the
commitment to adopt international accounting standards for ?nancial reporting periods
beginning on or after 1 January 2005. The other CLERP bills related to corporate governance
are CLERP3 on Directors’ duties and corporate governance, CLERP4 on improving takeover
regulations to promote a more competitive market and CLERP9 on addressing a number of
reforms in audit and corporate disclosures.
4. Recent value-relevance studies based on Ohlson’s (1995) model include Marquardt and
Wiedman (2004), who ?nd a signi?cant decrease (increase) in the estimated coef?cients of
net income (equity book-value) for the year of seasoned equity offerings. Ghosh et al. (2005)
?nd that ?rms which report sustained increases in earnings due to sustained growth in
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revenues, report higher earnings response coef?cients (ERCs) compared to ?rms that achieve
earnings increases by reducing costs. Kallapur and Kwan (2004) investigate the
value-relevance of acquired brand assets reported by the UK ?rms. The authors report
that managerial estimates of brand assets have signi?cant positive associations with market
value of equity.
5. Holthausen and Watts (2001) and Barth et al. (2001) survey the value-relevance research
from contrasting perspectives.
6. The empirical literature on earnings management is voluminous. For reviews see Healy and
Wahlen (1999), McNichols (2000) and Fields et al. (2001).
7. Recent studies have started investigating a broader set of outcome measures in?uenced by
corporate governance structures. Ajinkya et al. (2005) and Karamanou and Vafeas (2005)
report that ?rms with more outside directors and greater institutional ownership are more
likely to issue management forecasts and these forecasts appear to be more speci?c, accurate
and less optimistically biased. Byard et al. (2006) ?nd that quality of ?nancial analysts’
information about forthcoming earnings increases with the quality of corporate governance.
Vafeas (2000) reports that ?rms with smaller boards in the sample are perceived by market
participants as being more informative compared to ?rms with larger boards. However,
Vafeas ?nds no evidence that strong outside board representation improves the
return–earnings relationship.
8. ASX (2003, p. 31), for example, states that “audit committees should meet often enough to
undertake its role effectively.”
9. Vafeas (2000), however, controls for the known determinants of the ERCs like size, leverage,
negative earnings, beta, and insider ownership in a regression of market-adjusted returns on
earnings interacted with board size and board independence dummies. His focus on board
size and board independence as the only governance variables, however, masks the
value-enhancing function of audit committees.
10. Speci?cally, Lehn et al. (2007, p. 927) propose that “. . . ?rms with low market-to-book ratios
may be poorly run and, hence, more likely to be targets of control contests. If so, these ?rms
are more likely than other ?rms to adopt takeover defenses that affect the value of their
governance indices. [Another explanation is] ?rms with low market-to-book ratios are likely
to have fewer growth opportunities as compared with other ?rms. [If] low growth ?rms are
more likely to be targets of takeovers than other ?rms, these ?rms are more likely to adopt
takeover defenses as well.”
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Further reading
Amir, E. and Lev, B. (1996), “Value-relevance of non-?nancial information: the wireless
communications industry”, Journal of Accounting & Economics, Vol. 22, pp. 3-30.
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Economics, Vol. 31, pp. 105-231.
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future earnings?”, The Accounting Review, Vol. 71, pp. 289-315.
Corresponding author
Ahsan Habib can be contacted at: [email protected]
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